Types of Stock
Non-qualified stock options (NQSOs)
Non-qualified stock options (NQSOs) are the most common. Exercising NQSOs triggers ordinary income tax on the difference between your exercise price and the stock’s market value. Your employer will usually withhold income tax, Social Security and Medicare upon exercise. Later, when you decide to sell the shares, either immediately or after a holding period, any gains or losses will be subject to either long- or short-term capital gains tax rules.
Incentive stock options (ISOs)
Incentive stock options (ISOs) are less common, but popular in the tech sector both for start-ups and mature firms. Usually, there are no taxes upon exercise, but exercising can trigger AMT taxes. If you then hold the shares for more than two years from the date of grant and more than one year from the date of exercise, you incur favorable long-term capital gains tax (rather than ordinary income tax) on all appreciation over the exercise price.
Restricted stock
The value of the stock grant (less the cost basis) is treated as compensation and is subject to ordinary income and payroll taxes—but timing matters. You’re allowed to make a so-called section 83(b) election within 30 days of the grant. This notifies the IRS that income tax on the stock should be assessed based on the valuation at the grant date (rather than later, when it vests). Why would you do this? Once you pay taxes based on the stock’s value at the time of the grant, any future gains in the stock’s price will be treated as long- or short-term capital gains, depending on the holding period. If you wait until the restricted stock vests to pay taxes, and the stock’s price rises, you could end up with a bigger tax bill. Of course, there’s also the risk that the stock’s price will fall after the grant or if you leave your company before the stock vests, in which case you would have paid more tax than you needed to. The taxes you paid aren’t refundable.
RSUs
With RSUs, no shares are issued until shortly after vesting. At that time, the stock’s value (less the cost basis) is treated as compensation and is subject to ordinary income and payroll taxes. Any gain after the vesting period is treated as a capital gain.
*Basis is generally set by fair market value at option exercise or stock vesting date; holding period generally begins at exercise/vesting. Dual cost basis (ordinary and AMT) applies to ISO stock in a qualifying disposition. For treatment of basis and holding period under a Section 83(b) election, consult your tax expert.
When do you pay taxes?
Different types of equity compensation can be taxed in very different ways.
NQSOs, ISOs, and RSUs aren’t taxed when granted, but you can elect to pay tax on restricted stock. You won’t pay tax on NQSOs and ISOs when you vest, but you’ll owe on the spread when you exercise them. Gains on all option types are taxed when sold.
NQSOs: You are taxed when you exercise your options. The tax is based on the spread between the stock’s fair market value and the exercise price of the option. The value of the spread is treated as compensation and subject to ordinary income and payroll taxes.
ISOs: You generally aren’t taxed until you sell the stock after exercising your options, giving them a potentially more favorable tax treatment than NQSOs. However, you must meet certain requirements to take full advantage. If you hold the stock for more than two years after the date the options were granted and at least one year after exercising them, the spread is taxed at the long-term capital gains rate, which is generally lower than your income tax rate. This is called a qualifying disposition. (Note: If you are subject to the alternative minimum tax (AMT), qualifying dispositions lose some of their tax advantages as the spread could be treated as income in the tax year you exercise your options, potentially leading to additional taxes.) If you sell before these criteria are met, the spread at the exercise date is taxed as ordinary income, and any gains after the exercise date will be taxed as either a short- or long-term capital gain, depending on the holding period. This is called a disqualifying disposition.
Restricted stock: The value of the stock grant (less the cost basis) is treated as compensation and is subject to ordinary income and payroll taxes—but timing matters. You’re allowed to make a so-called section 83(b) election within 30 days of the grant. This notifies the IRS that income tax on the stock should be assessed based on the valuation at the grant date (rather than later, when it vests). Why would you do this? Once you pay taxes based on the stock’s value at the time of the grant, any future gains in the stock’s price will be treated as long- or short-term capital gains, depending on the holding period. If you wait until the restricted stock vests to pay taxes, and the stock’s price rises, you could end up with a bigger tax bill. Of course, there’s also the risk that the stock’s price will fall after the grant or if you leave your company before the stock vests, in which case you would have paid more tax than you needed to. The taxes you paid aren’t refundable.
RSUs: With RSUs, no shares are issued until shortly after vesting. At that time, the stock’s value (less the cost basis) is treated as compensation and is subject to ordinary income and payroll taxes. Any gain after the vesting period is treated as a capital gain.
Planning considerations with stock options
Vesting
Typically, you must continue to work for a company for a specified length of time before you're allowed to exercise stock options. This length of time is called the vesting period, which can be all at once or gradually over time. Once you're vested, you have the right to exercise the shares. On the other hand, you have no control over unvested shares—you can’t exercise or benefit from them until you vest.
Timing
Because stock options have an expiration date (typically 7 or 10 years), it’s important to think ahead. Waiting until options approach expiration can limit your flexibility in making a more strategic decision and also lead to higher taxes. Even worse—your options may expire unused.
Taxes
Taxation issues related to exercising and selling NQSOs and ISOs can be complex. For example, even if your employer will withhold income taxes when exercising NQSOs, this amount may be inadequate and leave you with a big tax bill. With AMT considerations at exercise and special tax rules around selling, ISOs are even more complicated and require more tax planning.
Concentration
While it’s great to show your allegiance to your company, taking concentrated bets in any stock—particularly your own company stock—can lead to financial ruin. Stay diversified and use caution when holding more than 20 percent of your portfolio in any one position. Remember, you already have considerable exposure to the financial success of the company as an employee!