Stock Options: NQOs vs. ISOs

I have written a bunch of different posts over time on the different types of equity incentives a startup or emerging company can offer its workers. Below is a list of some of them.

What Type of Equity Incentive Should I Use?

What’s Better for an Equity Incentive–Restricted Stock or a Stock Option?

Incentive Stock Options vs. Nonqualified Stock Options

Top 6 Reasons to Grant NQOs Rather Than ISOs

LLC Compensatory Equity Awards: Difficult and Complex

ISOs or NQOs?

I still regularly get asked this question: Should I grant NQOs or ISOs?

One thing you have to remember if you are going to grant ISOs is that they are subject to more limitations and restrictions than NQOs, and their tax consequences are more complex and difficult to ascertain than the tax consequences of NQOs. In short, ISOs are more complex than NQOs. Thus, if you want to keep your life simpler, you would just choose to use NQOs so that you don’t have to worry about the varying consequences and limitations of the two different types of worker stock options.

What Are The ISO Tax Benefits?

When Congress put in place Section 422 of the Internal Revenue Code, it was trying to make life easier for workers. The benefits that Congress was trying to put in place were:

  • No ordinary income tax on exercise; and
  • Capital gain on ultimate sale of the stock, if the two holding periods were met.

The problems:

  • The spread on the exercise is an Alternative Minimum Tax Adjustment, that has to be reported to the IRS. The AMT taxes due can be significant. They can in fact be so significant they effectively prohibit exercise because the employee can’t afford the taxes.
  • The employee has to meet two holding periods to qualify for the benefit. They have to hold the option shares for at least one year after exercise and at least two years after option grant. Most employees exercise in connection with a liquidity event and thus don’t meet the holding period requirements. If you don’t meet the holding period requirements the option is taxed as an NQO.

Summary of Differences

  • ISOs can only be granted to employees. You can’t grant ISOs to independent contractors or board members who are not employees. What this means is that–if you decide to grant ISOs to your employees, you are almost certainly going to have to also utilize NQOs. One reason I favor using NQOs for all types of awards is because it is simpler–you only have to figure out and explain the tax consequences of one type of award to your workers–not two.
  • ISOs have two holding periods.  Most employees won’t meet these requirements and thus not benefit from the ISO tax benefits.
  • ISOs have to be priced differently for 10% or greater shareholders.
  • For 10% or greater shareholders, ISOs can only have a 5 year term. NQOs are typically 10 year duration options.
  • ISOs give rise to Alternative Minimum Tax consequences. The AMT can be hard to figure out. This additional complexity makes life more difficult for everyone–the company and the employee.
  • You have to give the employee and the IRS notice of the amount of the spread on the ISO that is subject to AMT, by January 31st of the year following exercise. This creates somewhat of a trap for employees. With an NQO, you have to calculate the tax withholding on exercise. An employee can’t exercise until the company has calculated the withholding tax and made the employee write a check to the company for the employee withholding portion. This avoids a situation where the employee doesn’t understand the tax consequences until the subsequent year. There have been plenty of employees who realized too late they owed too much AMT–and that they couldn’t afford to pay it. This is a result that is usually avoided with NQOs.
  • There is a $100,000 annual limitation on the amount of ISOs that can become exercisable during any calendar year.
  • You can’t grant immediately exercsable ISOs without problems.
  • NQOs give rise to a tax deduction for the company. The spread on an ISO exercise is not deductible by the company. The spread on NQO exercises can add up to very substantial tax savings for companies.

ISOs Still Better for Employees

Having said all of this–ISOs are still more favorable to employees than NQOs. It is still possible for an employee to achieve a better tax result with an ISO than with an NQO. It might be unlikely, but it is possible.

Conclusion

If you really want to give your employees the best they can possibly get–use ISOs. If you want to keep your life simpler, and you understand that for the most part employees are typically not going to benefit from the potential tax benefits of ISOs, use NQOs.

Public Policy Recommendation

Congress ought to repeal the tax on transfers of illiquid stock to workers.

This would allow companies to transfer stock directly to workers without requiring the employee to write a big check to the employer to cover the employee’s share of income and employment tax withholding.

I am not sure of the public policy rationale for making it harder for companies to give workers equity. It doesn’t make sense to me.

 

 

Compensatory Equity: Securities Law Considerations

Thank you to Lauren Hakala at Practical Law and to my colleauge Susan Schalla for writing the attached article with me.

Start-up Equity Awards Securities Law Considerations

In this article we go into the securities law issues companies have to confront before they issue compensatory equity awards to employees and service providers. Believe it or not, you can’t just issue your employees stock or stock options without first finding and complying with an applicable securities law exemption.

For stock option grants, this can mean filing forms and paying fees in various states in which you have employees. And on each option grant you also have to determine whether you have exceeded mathematical limitations imposed by the federal securities law. It is unfortunate that the law puts limitations on how easily you can share equity with workers. This doesn’t make sense, and Congress and/or the SEC ought to revisit the thinking that went into setting these limitations. Regardless, they exist today, and we have to comply with them.

What is Rule 701?

Rule 701 is the federal securities law exemption for stock options. It contains a number of limitations.For example:

  • You can only use Rule 701 to grant compensatory equity awards (as an incentive for services).
  • You can’t rely on Rule 701 to raise capital.
  • You can only make awards to individuals (no entities).
  • You are limited in the amount of equity you can grant in any 12-month period to the greater of one of three measures.
  • Despite compliance with federal law, you must still comply with state law (i.e., there is no federal preemption in this area).

How To Issue Compensatory Equity Awards Such as Options to Workers

I’ve written a blog post titled, Stock Option Grant Checklist, if you are interested in the mechanical steps required to technically and in compliance with law grant stock options.

I hope you enjoy the Practical Law article. 

 

Stock Bonuses Ought Not Be Taxable

You would think that stock bonuses to employees would be encouraged as good for societal and worker welfare.

However, this is sadly not the case.

The Tax Problem with Stock Bonuses to Employees

Here is the problem with employers paying stock bonuses to employees:

  • Stock bonuses are taxable just like cash compensation, despite the fact that the stock may be stock in a private company and not salable.
  • Both income and employment taxes apply to employee stock bonuses.
  • To receive a stock bonus, unless the employer is going to pay the employee’s taxes (an unusual event) employees actually have to write checks to their employers so that their employers can satisfy the employee’s share of and employment tax withholding.
  • The amount of income and employment taxes applicable to stock bonuses can be so significant that most employees would rather forego the award rather than pay the tax.
  • This adverse tax treatment of employee stock bonuses results in employers resorting to stock options rather than stock bonuses.
  • Stock options are less favorable than stock bonuses for a number of reasons, including, among other things: (i) stock options have to exercised in order for the stock to be issued to the employee; (ii) taxes may be due on exercise; (iii) the taxes due on exercise may be so significant as to dissuade the employee from exercising in full; and (iv) stock options ultimately expire.

Public Policy Recommendations

Here is what Congress should do:

  • Repeal the taxation of transfers of private company stock to company workers.
  • This will allow companies to more readily share equity with workers, which will increase worker and ultimately societal welfare.

When Should I Sell My Vested Equity Compensation?

Vested Equity Compensation

Guest Post by Jordan Taylor, CPA/PFP – Co-Founder of VestBoard 

As the overall economy has continued to build positive momentum over the last few years, the IPO market has exploded, culminating in over $85 billion raised in 2014. With the recent surge, employees of these growing companies stand to capture the upside. The many varieties of equity compensation structures available to both C-level executives and key employees offer immense opportunities for planning and strategy around minimizing tax liabilities on an annual basis.

One common form of equity compensation is Restricted Stock Units (RSU’s), which are typically subject to a vesting schedule. A key component is the fact that they become compensation to the holder at the full market value (FMV) of the units that vested on that date. The employer will also sell certain shares to make withholding tax payments on behalf of the employee, which is reported on the W-2.

As mentioned above, employees of companies who have recently gone public–or are close to an IPO–stand to have significant wealth added to their bottom line. However, when tied to a wildly fluctuating stock price, it can be a bit unnerving.

Twitter is a good example. The company debuted on the New York Stock Exchange on November 7th, 2013 at $26 per share. After a monumental first trading day, it closed at $44.90. Fast-forward to 2014 and in less than seven months, the stock price went from a high of $74 to trading as low as $29 a share.

Imagine you worked for Twitter and had 100,000 shares as part of their compensation. Now picture the value of your portfolio falling from $7.4 million to $2.9 million in less than 7 months. If faced with a similar scenario it would certainly have me thinking about running for the exits (selling off all my shares). But before you consider doing that, keep in mind that it is also important to understand that blackout periods are common among companies. Blackout periods force employees to only have access to sell shares at various time periods (typically quarterly). Picture this: You may find yourself watching the stock price plunge to historic lows and not be able to do anything about it.

After reading the scenario above, it’s important to consider a few things related to RSUs:

  1. What is my cash situation?  – Depending on where your income has been historically and how much you are receiving in stock you would find yourself pay taxes at the top rates (39.6% Federal and 0-13% in your state). It is important to understand where your projected tax will fall so you can consider it for planning purposes.
  1. Do I hold for future long-term capital gains (LTCG)? – Your holding period starts when the stock vests, which means you would need to hold the stock for one-year to achieve LTCG treatment on any additional appreciation and if you have a crystal ball on where the stock will be in twelve months (or you have unbridled devotion to your employer) you may want to hold everything. If you received Apple stock or Amazon stock when they went to IPO years ago and never touched or sold everything, you would be doing just fine.
  1. Do I sell? – The benefit to selling immediately at vest is that you avoid any capital gains or losses, as your basis is the FMV on vest date and in most cases, the stock price hasn’t fluctuated significantly. You then have the cash available to either diversify or spend all of the money on toys, cars and fine art. All joking aside, it gives you flexibility and to leverage against having all of your eggs in one basket and to begin planning around a long-term strategy.

When faced with decisions regarding your equity compensation, make sure you consider the tax implications of holding/selling shares. It may be a one-time opportunity that you have to create lasting wealth for your retirement. Choose wisely!