The first thing to do with a grant of stock options is to understand which type of options you have and their tax treatment.

Stock options became famous during the 1990s. It was then that tech companies started to make broad-based option grants to rank-and-file employees, not just to executives, as a strategy to lure top talent. Even the TV sitcom Seinfeld took notice. "So," Elaine says to Jerry and George in "The Money" (1997), "you understand how my Peterman stock options are gonna work?" While George (of course) feels only petty resentment that she makes more than he does, it is a very good question. Before you exercise stock options and do any financial planning with them, you need to understand which type of options you have and their tax treatment.

Stock Options: The Basics

While since the 1990s many companies have come to favor other equity grants, such as restricted stock units (RSUs) and performance shares, stock options remain a major form of equity compensation. Stock options give you the right to purchase a specified number of shares of the company's stock at a fixed price during a set timeframe. The purchase is called the exercise, and the fixed price set at grant is called the exercise price. Typically, you must continue to work at the company for a specified period before you are allowed to exercise any of the stock options. That length of time is called the vesting period, characterized by a vesting schedule.

Companies can grant two types of options: nonqualified stock options (NQSOs), the more common variety, and incentive stock options (ISOs), which offer some tax benefits but also raise the complexities of the alternative minimum tax (AMT). Before exploring the differences between NQSOs and ISOs, you must check your grant agreement and know which type of options you have. Many companies now have omnibus stock plans in which they are authorized to grant not only both types of stock options but also restricted stock, RSUs, performance shares, and stock appreciation rights (see, for example, Uber’s 2019 equity incentive plan). This is why you need to look at your specific grant to be sure of the award type you are receiving. If it's still not clear to you, then ask the stock plan administrator or person at your company in charge of managing the employee stock option plan.

Nonqualified Stock Options

Nonqualified stock options (NQSOs), the more common variety, are a type of stock option that does not qualify for special favorable tax treatment under the US Internal Revenue Code.

A nonqualified stock option (NQSO) is a type of stock option that does not qualify for special favorable tax treatment under the US Internal Revenue Code. Thus the word nonqualified applies to the tax treatment (not to eligibility or any other consideration). A few basic NQSO facts:

  • NQSOs are the most common form of stock option and may be granted to employees, officers, directors, contractors, and consultants.
  • Unexercised NQSOs can be transferred to others, such as upon divorce or gifting.
  • There is no tax-code limit on the total number or value of NQSOs that can be granted.

You pay taxes when you exercise NQSOs. For tax purposes, the exercise spread is compensation income and is therefore reported on your IRS Form W-2 for the calendar year of exercise.

Example: Your NQSOs have an exercise price of $10 per share.
  • You exercise them when the stock price is $12 per share.
  • You have a $2 spread ($12 – $10) and thus $2 per share in ordinary income.
  • You sell the stock at $16 per share, giving you $4 per share in capital gains ($16 –$12 tax basis). Whether the gain is long-term or short-term depends on your holding period after exercise.

When you exercise NQSOs, your company will withhold taxes: federal income tax, Social Security (up to the yearly limit), Medicare, and state taxes (if applicable). This withholding appears on your Form W-2 for that calendar year.

When you sell the shares, whether immediately at exercise or after a holding period, you need to report the stock sale on Form 8949 and Schedule D of your IRS Form 1040 tax return. For a detailed explanation of the tax rules, see the related sections of the Tax Center on this website.

Incentive Stock Options

Incentive stock options (ISOs) offer special tax benefits but also raise the complexities of required holding periods and the alternative minimum tax (AMT).

Incentive stock options (ISOs) qualify for special tax treatment under the Internal Revenue Code and are not subject to Social Security, Medicare, or withholding taxes. However, to qualify they must meet criteria specified under the tax code:

  • ISOs can be granted only to employees, not to directors, consultants, or contractors.
  • There is a $100,000 limit on the aggregate grant value of ISOs that may first become exercisable (i.e. vest) in any calendar year.
  • For an employee to retain the special ISO tax benefits after leaving the company, the ISOs must be exercised within three months after the date of employment termination (longer periods apply for disability and death).
  • Unlike NQSOs, ISOs cannot be transferred to others (e.g. upon divorce or by gifting).

ISO Holding-Period Rules: Benefits But Risks

After you exercise ISOs, if you hold the acquired shares for at least two years from the date of grant and one year from the date of exercise, you incur favorable long-term capital gains tax (rather than ordinary income tax) on all appreciation over the exercise price.

Meeting the holding-period requirements of an ISO can result in substantially lower taxes.

Example: Your exercise price is $10, i.e. the stock price at grant. You exercise when then market price is $15.
Holding period Sale price Taxable income
Less than 1 year from exercise* $17 $5 ordinary income (reported on W-2) + $2 short-term gain
1+ year from exercise, 2+ years from grant $17 $7 long-term capital gain, no ordinary income
*ISO taxation depends on: (1) when shares are sold; (2) the sale price relative to the exercise price and the market price at exercise.

However, the exercise spread on shares acquired from ISOs and held beyond the calendar year of exercise can subject you to the alternative minimum tax (AMT) and additional tax-return reporting (e.g. Form 6251). This can be problematic if you are hit with the AMT on paper gains but the company's stock price then plummets, leaving you with a big tax bill on income that has evaporated.

Alert: If you have been granted ISOs, you must understand how the AMT can affect you. You should do an AMT calculation whenever you exercise ISOs and hold the shares.

Summary

The table below summarizes and compares selected major traits of NQSOs and ISOs.

Option type Eligibility Event that triggers taxes Taxes Withholding? Tax at sale
NQSOs Company employees, executives, directors, contractors, and consultants Exercise Ordinary income tax, Social Security, and Medicare on the exercise spread Yes, at exercise Capital gains tax
ISOs Only company employees and executives Sale, unless AMT incurred Ordinary income tax, AMT, or none* No Capital gains tax*
*ISO taxation depends on: (1) when shares are sold; (2) the sale price relative to the exercise price and the market price at exercise.

Further Resources

For more knowledge and financial-planning insights on these different types of stock options, see the NQSO and ISO sections of this website. To discover what your gains would be after exercising options and selling the stock, try the site's Quick-Take Calculator for Stock Options and other tools. For potential differences in these grants at private companies, see the section Pre-IPO.