The tax law creates a special type of employee stock option called an Incentive Stock Option (ISO). ISO’s receive preferential tax treatment relative to “nonqualified” options. The advantages are as follows:
- The tax basis in the purchased shares at the time of exercise is the employee’s out of pocket cost (the “strike price” times the number of shares).
- No income is recognized until shares are sold, providing an option to defer the tax.
- Any gain recognized at the time of the sale is considered capital gain.
To illustrate, assume the following example:
In year 1, Mr. Smith is issued stock options to purchase 2,000 shares of XYZ stock @ $50/share. At the time the stock options are granted, XYZ stock is trading at $50/share. Because the strike price is equal to the market price, no taxable income is recognized. In year 5, the options are exercised when the stock is trading at $120/share, and the shares are sold simultaneously.
If the options qualify for ISO treatment, the tax is calculated as follows in year 5:
Gross proceeds: $120/share, or $240,000
Out of pocket costs to exercise options: $50/share, or $100,000. This is considered basis.
Net proceeds of $140,000. Proceeds are considered capital gain, and taxed at rate of 15%.
Total tax cost assuming 15% capital gains tax rate is 21,000.
Note that with ISO’s, the taxable event is triggered not by the exercising of the options, but by the sale of the stock. Therefore, if the taxpayer chose to exercise the options but not sell the stock, the taxpayer would defer any tax until the stock is eventually sold.
If the options were nonqualified, then the $140,000 in income would be considered ordinary income. Assuming a marginal tax rate of 35%, the tax due on the transaction would be $49,000.
In addition, with nonqualified options, the taxable event is triggered by the exercise of the options. Therefore, the taxpayer does not have the option of deferring the tax if he chooses not to sell the shares.