Updated: Oct 12, 2023
Our clients repeatedly ask about option taxation and valuation. There are many good articles on the topic but no charts or videos! We appreciate content that is concise and spoon-fed, so we created the graphs and video below to help you easily understand NSO and ISO taxation.
NSO taxation is simpler, so we’ll start with that. There are two taxable events for NSOs: The first occurs when the NSOs are exercised; the second occurs when the underlying stock is sold.
NSOs are granted with an exercise price, also called a strike price. When NSOs are exercised, that creates what is called a bargain element: This is the spread between the value of the underlying stock on the date the NSO is exercised and the strike price of the NSO. Ordinary income tax is imputed on the bargain element and employers are required to withhold income tax and pay FICA taxes on this amount.
When the NSO holder exercises, it ceases to be an option holder and becomes a stockholder instead. When the stockholder later sells the stock, capital gains tax is imputed on the difference between the price of the stock when it was sold and its value when the NSO was exercised.
How NSOs are Taxed
ISOs are a little trickier as the tax treatment is variable. We should first understand what constitutes a “qualifying disposition” of an ISO. A qualifying disposition is where the stockholder sells the stock at least one year after exercising the ISO and at least two years after the ISO was granted. In a qualifying disposition, all gain will be taxed as capital gains. An ISO holder might additionally owe AMT upon exercise because the ISO bargain element is what the IRS calls a “preference item.” If there is a disqualifying disposition, then the tax treatment matches that for NSOs (except the ordinary income from a disqualifying disposition is not subject to income and payroll tax withholding).
How ISOs are Taxed
We hope these charts have helped clarify this topic. At Mercovus Valuations, we have helped many clients understand the intricacies of stock options and valuations. If you have any questions or if you require assistance with quality valuations to meet critical tax compliance requirements, please reach out to us. We’d be glad to help.
Eric Sundheim, ASA