Technology Law Experts

The Practical Tech Lawyer: How Are Stock Options Taxed?

As explained in an earlier blog entry ("ISOs and NQSOs – What’s the difference?"), the U.S. federal tax code recognizes two types of stock options: "incentive stock options" ("ISOs") and "non-qualified" stock options ("NQSOs"). How are they taxed? The best way to understand the differences is to start with the basic tax model, which applies to NQSOs.

NQSO Tax Treatment. For an NQSO, there is no taxable event, either for the recipient or the company, when the option is granted.  There is also no taxable event when the option vests (becomes exercisable).

When an NQSO is exercised, the holder of the option pays ordinary income tax equal to the spread between the exercise price and the fair market value of the stock at the time of exercise. The company takes a corresponding deduction. The company must withhold the taxes owed from the employee. This all happens even if the holder of the option does not sell any of the stock when exercising. When someone sells shares received from the exercise of an NQSO, he pays capital gains taxes (short-term rates or long-term rates, depending on whether the shares were held for at least a year) on the spread between the fair market value of the stock at the time of exercise of the option and the fair market value of the stock at the time of sale (i.e., the sale price). 

As I noted in an earlier blog entry, Section 409A of the Internal Revenue Code is a potential pitfall for NQSOs. Because ISOs must be granted with an exercise price equal to or above the fair market value of the underlying stock, they are exempt from Section 409A.

ISO Tax Treatment. There is no taxable event, either for the recipient or the company, when an ISO is granted or vests. (This is the same for NQSOs.)

When an ISO is exercised …

  • If the shares are sold at the time of exercise or any time within on e year after the exercise or two years after the grant date (called a "disqualifying position"), the holder pays ordinary income tax, and the company receives a corresponding deduction, on the spread between the exercise price and the fair market value of the stock at the time of exercise.  But unlike the exercise of an NQSO, there is no company withholding obligation for a disqualifying disposition of an ISO.


  • If the shares continue to be held (not sold), then there is still no taxable event (except possible alternative minimum tax, or AMT) from the exercise.  When the shares are sold (after one-year anniversary of the exercise), the holder pays a long-term capital gains tax on the spread between the exercise price and the fair market value of the stock at the time of sale.


So the main advantages of an ISO over an NQSO are (a) capital gains tax treatment, instead of ordinary income tax treatment, on the spread between the exercise price and the fair market value of the stock at the time of sale and (b) the absence of a company tax withholding requirement when ISOs are exercised.


If an ISO is structured and documented correctly, then the biggest hurdle to receiving this favorable tax treatment is the pesky obligation to hold the shares for at least a year after the option was exercised.  It takes a special situation to make this happen.  I don't know many employees of privately-held companies who would exercise an option and hold the shares for a full year.  I can imagine situations where this might be a rational thing to do, such as when an employee leaves the company and wants to hold some shares in case of a future sale of the business, or when the shares from an optin exercise have a meaningful impact on control issues like voting and shareholder information rights.  But I've rarely seen it done.  The risk of paying for the shares and then helplessly waiting for a liquidity event is just too great for most people.

With public companies, where market prices for the stock fluctuate constantly, the risk of holding shares is also quite steep for many employees. But at least the stockholder of a public company knows there’s a market where he can bail out of his shares if things start to fall apart, and he can look up the value at any moment. I have seen employees of public companies exercise ISOs and hold them long enough to get ISO tax treatment. I’ve done it myself, in fact. But as a former officer of a public company, I have also found myself caught in a blackout period – where insiders are prohibited from trading in company stock due to knowledge about impending material news that has not yet been announced publicly – and helplessly watched the value of my shares sink. It cost me a lot of money. If I ever exercise an ISO again, I will sell the shares right away. I won’t exercise and hold.


© 2013 by Robert G. Schwartz, Jr. All rights reserved
 Disclaimer: This summary is provided for educational and informational purposes only and is not legal advice. Any specific questions about these topics should be directed to an attorney.

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