Learn the ins and outs of Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs) and how to be tax efficient with these options.
Learn the ins and outs of Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs) and how to be tax efficient with these options.
hello, this is chase Berkey here. Again, for another episode of taxes made simple. I'm the CEO and co-founder around these parts and I'm not going to lie. I'm kind of a big deal. So you're welcome. Kidding. Of course, Natalie Cohen runs the show around here, or at least she's running the show today. Today's episode builds on the previous speed round of stock compensation. We're going to dive deeper into ISO's and NSS, which you probably knew since you selected this episode, the format is going to be the same rapid fire Q and a in five minutes or less, our producer, however politely informed us that we went over time on our last episode. So this time I promise you, we will stay under five minutes. Okay, let's get it out, Natalie. Thanks again for volunteering to drop some knowledge on our listeners from your office in Portland, Oregon. Thanks, chase. Happy to be here again, going to do my best to keep it under five minutes this time. Uh, what kind of coffee are you drinking today? I've got some strong coffee with me today. Well, that's the best kind. I prefer my coffee to look like Turkish crude oil. All right. So as a reminder, ISO is shorthand for incentive stock option and NSO is short for non-qualified stock option. Natalie to recap our last episode. What is an I, sorry, what is an NSL? An NSL is an option to buy a certain number of shares at a certain price. When you exercise the option, you have to pay tax on the difference between the price you paid for the stock and its actual value at the time you bought it. Awesome. And what is an ISO? So an ISO is like an NSO, except there's no tax due. When you exercise the option in certain circumstances, you might know alternative minimum tax. When you exercise an ISO. Therefore, I suppose, are generally taxed once the actual shares have been sold, but how would an ISO recipient know if AMT was owed when they exercise the stock? Honestly, they probably wouldn't. The calculation is complex and requires substantial knowledge of the tax code. Generally, if their income is about 200,000 prior to the exercise, they would be wise to reach out to CPA, to perform this calculation and determine the amount of estimated taxes that need to be paid in. But there's a positive side here. Right? How does getting hit with AMT potentially benefit you in future tax years? So if you do have to pay AMT, you'll create a tax credit for future years that you can use when your regular tax exceeds AMT. Gotcha. So who exactly can receive an ISO only employees of the company? Whereas Anissa is, can be granted to just about anyone involved with the company. And from the standpoint of an employer, which is more advantageous ISO's or NSS, generally speaking in Osos are more advantageous because they have less restrictive stock. Generally speaking MSLs are more advantageous because they have less restrictive requirements than ISOs. And when an employee exercises, the option, the employee gets to deduct the amount of ordinary income that the employee has to pick up. As a reminder that income to the employee is the difference between the exercise price and the fair market value at the time of exercise. So other than the requirement that ISO's only be issued to employees, what other restrictions do ISO's have? They must be nontransferable no more than a hundred thousand of stock can be exercised each year. And if an ISO recipient owns greater than 10% of the company, the exercise price must have at least a 10% premium over fair market value. And I would imagine that sophisticated listeners of the podcast would likely have heard of a four Oh nine a valuation, what is a four Oh nine evaluation and windows and employer have to do it. Yeah. So this is actually an area where it's easier for the company to have an ISO plan instead of an NSO plan. Since it's only required for innocence, a four 90 evaluation is essentially evaluation done by an appraiser to determine fair market value of the company and its shares. It's not cheap and it may not yield the results of the company or employee was hoping for employers must perform this valuation at least once a year or whenever a material event occurs that would affect the value of the company. On the other hand, ISOs only need to have a good faith valuation determined by the board of directors. So switching gears back to the employee side, what does an ISO recipient need to do to ensure the most favorable tax treatment? Can you to ensure that they hold the stock after exercise for at least a year. This means one year and a day at a minimum, they also need to make sure that they don't sell the stock before two years after the date of grant of the ISO. Again, this means two years and the day after grant date at a minimum. And what about NSS? What can people do there? The best thing they can do is to exercise the stock as soon as possible to start the holding period of the stock and reduce the amount taxed as ordinary income versus long-term capital gains. If the NSO is unvested when you exercise, then you need to consider making an 83 B election. Otherwise the ordinary tax burden will occur when the stock invests, which will be later down the road. When the stock may be worth substantially more. And could you remind our listeners again? What exactly an 83 B election is? Yeah. So an 83, B election is an election made by someone who has unvested options or shares that is electing to be taxed on the value of equity. Now, before at best, they make the election with their employer and IRS, and it must be done within 30 days of the grant date. I'll say that again for good measure. An 83 B election must be done within 30 days of the grand bait. Well there, you have it folks. I think we're actually under the five minute Mark. This time. Join us for our next speed round where we'll dive deeper into NSOC and And now for the disclaimer, the content in the proceeding podcast should not in any way be construed to be tax advice. All tax laws are nuanced in. Those are applied to each unique situation differently. Don't be a dummy IRS CPA, preferably a darker CPA.