Employee Stock Options: The Primer

Both ISO and NSO are terms for options companies issue on their stock. Why the two types, and what are the rules? We explain by examining tax history.

 

The IRS gives preferential tax treatment to certain types of stock options that companies grant to employees. These options are called incentive stock options or ISOs. This preferential treatment can majorly impact your budget on tax day. But what kind of options qualify to be ISOs, and what is an NSO?

Before I provide an itemized list of legalistic-looking rules and send you into a formalistic tailspin trying to classify your options, let us look back to the beginning of the 20th century. The letter of the law becomes less opaque if one reads it through the lens of its intent, and to understand the intent, we will use history as our guide.

We will discuss why, at the beginning of the 20th century, companies started issuing options on their stock, and how the government initially decided to tax these grants. We’ll briefly look at the pushback corporations staged to get better tax treatment.

We’ll then return to the rules that we abide by today. By then, you will see the reasons behind the rules. You might even find yourself guessing what type of options you have without having to look at your grant agreements. But if you’d rather just read the rules, you can skip the history and go directly to the explanations.

This post is a part of my comprehensive series on employee stock options. To see the introductory post about how options work, click here.

In future posts, we’ll address other aspects of employee stock options—vesting, taxation, what your options might be worth, how to exercise them, and, of course, strategies for the best time to exercise your options and how to balance the risks of options and other investments in your portfolio.

Table of Contents

ISO confused

The ISO terminology you need to know

There are two types of options companies grant on their stock — incentive stock options, or ISOs, and non-qualifying stock options, or NSOs (or, sometimes, NQSOs).

The term incentive stock option is defined in § 422 of the Internal Revenue Code (Title 26 of the US Code). As far as I know, the term non-qualifying stock option isn’t defined anywhere, but it is widely used by practitioners to refer to any options that are not ISOs — options issued by companies on their stock that don’t qualify as ISOs.

Economically, both option types are the same (see our post about how options work). But the ways companies grant them, and how the IRS taxes them, are pretty different.

If specific rules are met, the IRS offers incentive stock options preferential tax treatment and considers them qualified. If not, the options do not qualify for the treatment and become non-qualified stock options.

Why does any of this matter to the everyday consumer? The answer is taxes. In 1913, the 16th amendment to the US Constitution gave Congress the ability to levy income tax. Initially, between 1913 and 1921, ordinary income and capital gains were taxed at the same rates, but, in 1922, Congress established a lower tax rate for capital gains.1

The highest ordinary income tax rate in 2021 is 37%, and the highest capital gains tax rate is 20%. On top of that, wages or earned income—your regular salary—are subject to additional taxes called FICA taxes: Social Security taxes (currently 6.2%) and Medicaid taxes (1.45%).

This is why it’s crucial to know how your stock options are classified. If your options are ISOs, the resulting income is taxed as capital gains and is not subject to FICA tax. If, on the other hand, your options are NSOs, the resulting income is taxed as wage income, with ordinary income tax and FICA taxes.

If you compare the taxation rates, it becomes clear that the way the IRS classifies your options makes a difference. When it comes down to it, ISOs will typically cost you less in taxes than NSOs.

But why do we have two types of options with such a vast difference in their tax treatments? To answer that question, let’s begin by looking at when and why companies started issuing options to employees.

Incentivize me!

The birth of the employee stock option plan 2

Before the 1900s, most companies in the U.S. were run by their founders; employees were paid salaries and left the business of worrying about corporate profits to the owners. Around the turn of the 20th century, the U.S. saw a business consolidation period; around 2000 small companies combined into 157 large corporations.

Handling new conglomerates became a serious business and shifted management responsibility from founders to skillful professionals, giving rise to a new profession—the corporate executive.

With stakes high, aligning the interests of the shareholders and the executives came into focus. Companies began tying bonuses to corporate profits and encouraging employees to own corporate stock. By the end of the 1920s, corporate bonuses accounted for 42% of executive compensation in companies with executive bonus plans.

But selling stock to employees turned out to be problematic—many employees did not have the means to buy the stock. To address the problem, companies started issuing stock options and offering the stock at a discount, which is similar to an in-the-money option.

We will tax you!

How the IRS wanted to tax employee stock options

With the 16th amendment ratified in 1913, in the 1920s, the tax law was only a decade old, and no one had yet figured out how to tax options. In 1922, Congress separated ordinary income and capital gains into distinct groups and established different tax rates for each. Corporations thought that because company stock is a form of invested capital, the gains from options, or the spread (that is, the difference between the stock price and the strike price), would be taxed as capital gains, not as ordinary income.

However, in 1923, the Treasury announced that it intended to tax the spread as ordinary income at the time of the options were exercised (that is, when the discounted stock was acquired.)

The Treasury might not have realized it at the time, but the new policy would set in motion a decades-long tug-of-war on CEO pay between corporations and the government.

In the 1920s, publicly traded companies did not have to provide any disclosures of pay for individual executives. The economy was doing well, and executive pay was rapidly increasing, with the public largely unaware of the magnitude of the highest CEO bonuses.

Then, in the fall of 1929, the United States saw the start of the Great Depression. Imagine the public outcry when, in July of 1930, a lawsuit attempting to block Bethlehem Steel from taking over another steel corporation inadvertently revealed a $1.6 million3 bonus the company’s CEO had received in 1929!

Regulators became interested in executive compensation, and regulations followed. Politicians who supported the New Deal, outraged by the perceived excess in CEO pay, pushed for disclosures, which resulted in the inclusion of executive pay disclosure provisions in the Securities and Exchange Act of 1934.

Before 1923, the Treasury Regulations did not make any reference to employee stock options or purchase agreements, but between 1923 and 1939, a series of regulations set up a presumption that any property acquired by an employee at a discount, such as exercising an in-the-money option and getting a stock valued higher than the strike price, would constitute compensation and should be taxed as ordinary income.4

Give us a break!

Why companies argued for a lower tax

Beginning in 1938, a series of lawsuits challenged the Treasury’s presumption that they could tax option compensation as ordinary income. The issue centered around the intent of an options grant and the substantiality of initial spread — the difference between the strike price and the stock price at the time of the grant. These principles still help determine the definition of ISOs today.

The companies argued that a small initial spread aligns with the interests of the employee and the company. For example, suppose the strike price of an option was set to the market price of the stock; at that point, immediately exercising the option would yield no economic gain. The option holder would then have to wait for the stock to appreciate to make any profit; they would be economically motivated to see the company succeed.

Therefore, the companies argued, if the grant intends to align employees’ and shareholders’ interests, and the initial option spread is small, the grant is not really compensation; it is a way to incentivize employees. After all, cash-like compensation provides an employee with immediately available funds, whereas company options with small spreads do not.

This idea eventually led to Section 218 of the Revenue Act of 1950. The Act distinguished proprietary options—which align the employees’ interests with the company’s—from compensatory options, which are intended, similarly to cash, as payments for services. According to Section 218, as long as specific rules were satisfied, the spread from stock options used as incentives would be taxed as capital gains at the time that the stock purchased upon exercise of the options was eventually sold.

It might be mind-boggling now, but in the 1950s, the maximum income tax rate was a whopping 91%, the highest in US history. In contrast, the top capital gains tax rate was 25%—not much higher than what it is now. You can imagine that, with such an enormous difference in tax rates, the 50s saw a rapid proliferation of ISOs.

You can’t do that!

Why Congress beefed up the rules

In the early 60s, amid the post-Korean-war recession, with the decline in the stock market, many options that had been granted in the 50s were out of the money. Companies, exploiting existing provisions of the law, started resetting option strike prices to lower levels or canceling old options and issuing new ones with lower strikes.

The practice became highly controversial. The issue was debated in Congress when, in 1964, it was revealed that “Chrysler officers who bought the company’s stock under a stock option plan last year and sold it before the year was out realized $4.2 million5 in capital gains.”6

While the 1964 Revenue Act kept the qualified option classification, it substantially reduced their attractiveness. This trend continued until, in 1976, the 94th Congress banned all future grants of qualified stock options altogether. However, in 1981, the 97th Congress resurrected qualified options in a new form, calling them Incentive Stock Options, or ISOs.

We will not go much further into the ebbs and flows of the regulations, but it’s easy to see how, with each pull in the tug-of-war on regulating employee stock options, the rules piled up, creating what remains to most of us a fog of confusion.

Despite the multilayered onion that is regulations, the underlying theme here is relatively simple. If you are trying to understand your options, keep this in mind: ISOs are company-aligned, forward-looking, employee-granted options. They bear preferential tax treatment and are likely to cost less in taxes in the long run. Everything else is NSOs and subject to ordinary income tax.

Them’s the rules

Modern IRS rules for ISOs explained

Now that we’ve taken the scenic route through the history of regulations, it’s time to unearth how our modern tax code defines ISOs and what this will mean for you—the grantee of company stock options. To do this, we’ll be looking at brief snippets of the tax code itself and discussing how each applies in layman’s terms.

To qualify for ISO tax treatment, the options must be issued according to a plan adopted by the company and approved by its shareholders, and your grant agreement should designate the options as ISOs. Further, you and your employer must follow various rules set out in the tax code.7

I’ll mention the most commonly quoted rules here, but please keep in mind that these are general principles; specific grant agreements and company plans may be written in a way that deviates from the below.

The tax code says:

  • the term “incentive stock option” means an option granted to an individual for any reason connected with his employment by a corporation

What this means:

  • You can only get ISOs if you are a W2 employee. Remember the intent of ISOs? Non-employees, such as contractors, consultants, or outside directors, cannot be granted ISO options.

The tax code says:

  • such option by its terms is not exercisable after the expiration of 10 years from the date such option is granted

What this means:

  • The options’ expiration cannot be more than ten years from the grant day. While the options’ term can be shorter, corporations typically set it to the max allowed. Remember that nothing needs to happen for your options to expire other than the passage of time. It is true for both ISOs and NSOs. If you’ve been with the company for a long time and have stock options grants — make sure to check the expiration dates of your options!

The tax code says:

  • the option price is not less than the fair market value of the stock at the time such option is granted

What this means:

  • ISOs must be offered at or out of the money, and they are usually issued at the money. Remember the fight over substantiality and how large the difference between the strike and the stock price is? The difference ought to be small, so you cannot turn around and immediately realize a profit; otherwise, it would be salary-like compensation.

The tax code says:

  • such option by its terms is not transferable by such individual otherwise than by will or the laws of descent and distribution, and is exercisable, during his lifetime, only by him; and otherwise than by will or the laws of descent and distribution, and is exercisable, during his lifetime, only by him

What this means:

  • If you transfer your options to someone else, you are simply engaging in tax arbitrage. The options are given to you as an employee to align your and the shareholders’ interests and cannot be transferred to others during your lifetime.

The tax code says:

  • at all times during the period beginning on the date of the granting of the option and ending on the day 3 months before the date of such exercise, such individual was an employee of [the company]

What this means:

  • The rule ensures that only employees get ISOs. With some exceptions for disability or death, you’ll have three months to exercise your options if you leave the company. After that, one of two things will happen: either the options stop being eligible for ISO tax treatment or expire. This is quite a difference! You’ll need to find out from your employer which option they’ve chosen, but in either case, they will no longer be ISOs.
  • When an employee leaves, the IRS allows employers to treat their options as NSOs. Still, most companies choose to expire the options. Beware that the options plan or your grant may even set a period shorter than three months for you to exercise the options! In all likelihood, if you are in this situation, you will have to exercise your vested options soon after you quit.

The tax code says:

  • such individual, at the time the option is granted, does not own stock possessing more than 10 percent of the total combined voting power of [company stock] … [except when] the option [strike] price is at least 110 percent of the fair market value of the stock … and such option by its terms is not exercisable after the expiration of 5 years from the date such option is granted.

What this means:

  • If you own at least 10 percent of the company, your ISO options’ exercise price must be at least 110 percent of the stock price, and the options’ term cannot be longer than five years. This limitation is unlikely to affect most employees but may be important for executives of startups and smaller companies.

Parting thoughts

These are not the only rules related to ISOs—far from it. There is a 100k rule—a limit to how much ISO compensation an employee can get in a given year. There are rules related to how soon you can sell the stock acquired by exercising ISOs. If you still have questions, fear not; we’ll dive into the details of ISO and NSO rules, taxation, and what you should plan for when your ISOs vest in upcoming posts in this series.

For now, we’ve waded through the history of US taxation rules to help you understand the reasons behind the difference between ISOs and NSOs. ISOs are options that qualify for lower capital gains tax rates when the stock acquired by exercising the options is eventually sold. NSOs are subject to higher ordinary income tax rates—including FICA taxes—when they are exercised.

If you’re still unsure what kind of options you have, remember the intent (ISOs are intended as incentives) and the substantiality of the spread (the initial difference between the stock’s value and the strike price must be small). Use your deeper understanding of ISOs to make sound financial planning decisions—and if you’re leaving your employer soon, or have been with the company for a long time, be sure to make a plan to exercise your options before they expire.

  1. Top Federal Income Tax Rates Since 1913 – Citizens for Tax Justice http://www.ctj.org/pdf/regcg.pdf
  2. The material in this and the following sections is largely drawn from Murphy, K. J. (2012). Executive compensation: Where we are, and how we got there. George Constantinides, Milton Harris, and René Stulz (eds.), Handbook of the Economics of Finance. Available at SSRN 2041679.
  3. $24.8M in 2021 dollars.
  4. Schneider, G. A. (1950). Taxation–Employee Stock Options under the Revenue Act of 1950–A Return to the Bargain-Purchase Concept. Marq. L. Rev., 34, 211.
  5. $36.4M in 2021 dollars.
  6. “CHRYSLER CHIEFS GAIN $4 MILLION; Treasury Discloses Report of Stock Option Sales,” New York Times (1964)
  7. 26 U.S. Code § 422 – Incentive stock options https://www.law.cornell.edu/uscode/text/26/422

Jan Pevzner, CFP®, EA

I am a Certified Financial Planner working with clients locally in New York City and virtually throughout the US.