Knowledge is power. I find myself thinking about this often when I’m advising clients on their equity compensation plans. In fact, I thought of it recently as I read that 48 percent of employees with stock options haven’t made any decisions regarding exercising or selling because they don’t want to make a mistake.
If you’re sitting on stock options because you don’t know enough about them, you could be missing out on a huge opportunity to grow your wealth. Gaining knowledge about the stock options you have or are being offered can make decision making and strategizing about those options so much easier.
As an executive financial advisor, part of my job is simply to educate clients about the stock options they’ve been offered so we can devise a strategy together. With that in mind, I’d like to offer a closer look at differences between two common types of stock options you may face at some point in your career—incentive stock options vs. non-qualified stock options.
Incentive Stock Options vs. Non-Qualified Stock Options: Tax Differences
The biggest difference between incentive stock options (ISOs) and non-qualified stock options (NQSOs) are the way in which they are taxed. So it’s a good place to start when talking about the differences between these two options.
The taxation of NQSOs is pretty straightforward. NQSOs are taxed at the ordinary income rate in the year in which they are exercised, and they can typically be exercised at any time.
Meanwhile, ISOs are treated as company-offered incentives to encourage employee longevity, so they are often held to a vesting schedule and possibly other rules regarding when they can be exercised and sold. How ISOs are taxed will depend on when you exercise your options.
Most of the time, ISOs will be taxed at the long-term capital gains rate, which has a maximum rate of 20%. You achieve this tax rate if you meet qualifying disposition status, which typically means the sale of the stock is made at least two years after the options are granted and one year after the options are exercised. The long-term capital gains tax rate is more favorable for top-level executives than the ordinary income tax rate.
Of course, there are extenuating circumstances that can change these tax scenarios.
For example, imagine that the company that offered you stock options is sold. If the options were ISOs, the federal tax benefit could be eliminated because you could be forced to exercise and sell your stock in the same day. This would prevent you from meeting the requirements necessary to achieve the long-term capital gains tax treatment. Now, you could face a short-term capital gain, which would be taxed at your ordinary income rate—the same rate as an NQSO.
This is one reason why it helps for top-level executives to work with a financial advisor in planning their stock option strategy. An expert can help you plan for the worst-case scenario, such as a company buy out or sell off. Even better, an advisor can look into the company’s financials and track record to help you decide if you should even opt into the stock options being offered to you in the first place.
Other Key Differences
Aside from the taxation differences of incentive stock options vs. non-qualified stock options, there are a few other differences worth noting:
Eligibility. ISOs are strictly for company employees. However, if you do any consulting work outside of your current employer, there’s a chance that the organization you consult for could offer you NQSOs as a form of payment. It’s not a common occurrence but it can happen.
Corporate tax favorability. Employers are able to deduct the NQSOs they grant on their corporate taxes, making this form of stock options more favorable for companies. ISOs do not have this tax-deductible benefit for companies. This is one of the reasons why most seasoned companies do not offer ISOs to executives and other employees.
If, however, you work for a startup company, you may be more likely to be offered ISOs. The major reason for this is because new companies don’t yet have a large taxable income that they need to offset with deductions. They do, however, have tremendous upside potential, so employees might be willing to work for a lesser salary and be compensated with more ISOs if they believe the company stock price will continue to rise.
Ease of use. In addition to the tax benefits NQSOs offer companies, these stock options are also more flexible and easier to administer on the corporate side than ISOs, which is another selling point for most companies.
So, what does all this mean for you as an executive? Unless you happen to be the CFO, you likely aren’t making the decision to offer incentive stock options vs. non-qualified stock options to company executives and employees. This means you should know and understand the stock options provided to you. Seeking out the advice of a wealth manager seasoned in equity compensation planning is a wise first step to develop a strategy to use these benefits to your financial advantage.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for integrated asset allocation and equity compensation management. For more information on how Wade and the Carpenter Team can advise you on incentive stock options vs. non-qualified stock options, reach out today for a complimentary consultation.
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