Specific Types of Equity Compensation: Incentive Stock Options and Non-Qualified Stock Options
Jeff Storch | 12.13.21
This is the fourth in a series of posts on equity compensation, focusing on stock options. Our prior posts are:
- An overview of equity compensation generally
- A discussion of restricted stock and restricted stock units (RSUs)
- A discussion of phantom stock and stock appreciation rights
Stock options are one area where the rules for corporations generally are different than the rules for partnerships, because of specific corporate tax sections.
Stock Options Generally
Employee stock options are a type of equity compensation that provides the employee with the right to buy employer stock at a specified exercise price at the end of a specified vesting period. The exercise price of a stock option is typically the fair market value of the share of stock at the time the option is granted. The vesting is commonly time-based (or, less often, performance-based). Options are exercisable for a specified exercise period after the option vests, typically for five to ten years.
Stock options are classified for tax purposes either as non-qualified stock options (NQSOs) or statutory stock options under Code Section 422, which include incentive stock options (ISOs) and employee stock purchase plans under Code Section 423 (which will not be discussed here). The tax treatment of stock options depends on the classification of the option.
An ISO is an option that is granted to an individual (in connection with employment) by the individual’s employer corporation or a parent or subsidiary of the employer corporation (a “related” corporation) to buy stock in the employer corporation or in the related corporation and that satisfies the ISO qualification requirements, which include:
- The option must be granted under a plan.
- The plan must specify the aggregate number of shares that may be issued on the exercise of options granted under the plan and the classes of employees eligible to receive options.
- Stockholders of the corporation granting the options must approve the plan within 12 months before or after it is adopted.
- The option must be granted within 10 years after the earlier of the plan’s adoption or the stockholders’ approval.
- The period during which the option may be exercised must end not later than 10 years after the option is granted.
- The option price may not be less than the stock’s fair market value when the option is granted, determined without regard to any restriction other than a restriction that, by its term, will never lapse. The option price is deemed equal to the date-of-grant fair market value, even if it is less, if there was “an attempt, made in good faith, to meet the requirement.”
- During the employee’s lifetime, the option must be nontransferable and be exercisable only by the employee, but it may pass at death to the employee’s heirs by will or the laws of intestate succession.
- When the option is granted, the employee may not own more than 10% of the voting stock of the employer, the employer’s parent, or any subsidiary of the employer. An option is excused from this requirement, however, if the option price is at least 110% of the stock’s value when the option is granted and the option’s term is not longer than five years.
- The option instrument must not state that the option is not an incentive stock option
Neither the receipt nor the exercise of an ISO is a taxable event. The employee is not taxed until sale of the underlying stock, taxed as capital gain. However, if the ISO stock is disposed of before the required holding period has run, the gain is includible in income, and a portion of that gain may be ordinary income.
The employer generally is not entitled to a deduction with respect to an ISO. However, if an ISO is disposed of before the holding period has run, then the amount of the ordinary income includible in the employee’s income is deductible by the employer.
An NQSO is any stock option that is not a qualified stock option under Code Section 422. Generally, the excess of the stock’s FMV when the option is exercised over the option price is taxable as compensation in the year of exercise. Unlike ISO holders who meet the required holding period, the recipient of an NQSO is not allowed either to defer income recognition on the bargain element until the stock is sold (being instead taxed on option exercise) or to have all the income associated with the option treated as capital gain.
Non-qualified stock options can be granted with an exercise price that is less than FMV on the grant date (referred to as discount options). However, this generally causes adverse tax consequences for the option holder under Code Section 409A.
This concludes our discussion of equity compensation issues.
DISCLAIMER: The information provided is for general informational purposes only. This post is not updated to account for changes in the law and should not be considered tax or legal advice. This article is not intended to create an attorney-client relationship. You should consult with legal and/or financial advisors for legal and tax advice tailored to your specific circumstances.