Know Your Employee Stock Options: NSOs, ISOs, RSUs and ESPPs
Employee stock options are a great way for businesses to attract and retain star employees, encourage company loyalty and build confidence in the business. There are three primary types of stock options that companies may grant to entice, reward and retain quality employees, including Non-Qualified Stock Options (called NSOs or Non-quals), Incentive Stock Options (called ISOs), Restricted Stock Units (called RSUs or GSUs if you work for Google). Many companies also offer Employee Stock Purchase Plans (known as ESPPs) as a way to reward employees and increase loyalty. Each has its own intricacies and specific benefits to both the employee and the company. Let’s take a closer look at each.
Non-Qualified Stock Options (NSOs)
Companies may provide Non-Qualified Stock Options (NSOs) to employees as an incentive or alternative form of compensation. Some smaller or emerging companies grant NSOs to employees in lieu of salary increases, or to attract top talent that may be otherwise beyond the company’s budget.
Non-Qualified Stock Options have become less popular in recent years but are still prevalent, especially for founders and early employees. An NSO grant gives the employee the opportunity to purchase a set number of shares of the company’s stock at a set discounted price (called the exercise price). The employee does not pay taxes upon receiving the NSO. The employee may or may not be given a time frame to exercise the NSOs.
Taxes and other costs are triggered when an employee exercises the option.
Exercise Date: 12/1/2020
Exercise Price $25
Market Price on Exercise date: $100
Number of Shares: 500
Exercise of NSOs:
Upfront Cost: 500*$25 = $12,500 to buy shares
Taxable Income that will appear on your W-2: ($100-$25) x 500 shares = $37,500
Most firms allow their employees to exercise the NSOs, immediately sell their shares and have all income, social security, state and medicare taxes taken out immediately so there is no cash flow burden up front or market risk in holding the stock. The cash remaining after exercise and taxes belongs to the employee free and clear.
The exercise and hold strategy: An employee may have plenty of cash on hand and decide to exercise the stock options, paying out of their own pocket and holding the stock for 366 days (when it becomes a long-term holding), at which point long-term capital gains are taxed at a lower rate than short-term capital gains or income. The employee will still have to pay the $12,500 to exercise the options and income tax on $37,500 compensation value.
This strategy carries “market risk”.
A year after the NSO has been exercised, the stock may or may not be at a higher value than the date of exercise. In this example, if the stock is trading at $50/share:
$50 (proceeds from sale) – $100 (cost basis) = -$50-$50 X 500 shares = -$25,000 loss
If the stock is trading above $100/share then you have a long-term gain:
$110 (proceeds) – $100 = $10: $10 X 500 = $5,000
It’s important to note that the terms of many NSOs require employees to wait a specific period for the stock options to vest. In most cases, employees can lose the options if they leave the company prior to the stock options vesting. Employees should be conscious of “clawback provisions” in NSOs that can enable the company to reclaim NSOs for reasons like bankruptcy or a full company buyout.
Incentive Stock Options (ISOs)
Incentive Stock Options, or ISOs, give employees the right to purchase stock shares at a discounted price while enjoying a tax break on the profit. ISO profits can be taxed at the long-term capital gains rate instead of the higher rate associated with ordinary income or short term capital gains. They can also be referred to as “statutory” or “qualified” stock options.
Publicly traded companies and private companies who plan to go public in the future use ISOs to encourage top management professionals and other high value employees to stay with the company for the long term. Companies also use them to compensate for lower annual salaries or as an incentive.
ISOs are issued at a set price by the company, called the “strike price.” In most cases, options have a vesting period before they can be exercised. The length of the vesting period is set by the company.
ISOs require a vesting period and a holding period before they can be sold and receive a more favorable tax treatment than NSOs. With an ISO, to get the most favorable tax treatment, shares must be held for more than one year from the date of exercise and two years from the grant date. Both requirements must be met for the profits to qualify as long-term capital gains instead of individual earned income.
Once the ISO vest, the employee can buy the shares at the strike price – or “exercise the option.” The employee can then sell the stock at its current value and keep the difference between the strike price and sale price as profit. (The taxable profit is the difference between the strike price and the price at the time of sale.)
Stock from ISOs can be sold any time after the options have been exercised, however each of the following circumstances has different tax treatment and you will need a tax professional to calculate the Alternative Minimum Tax (AMT) implications of various sale strategies.
- Exercise options and hold sock
- Exercise options and sell stock within the same year
- Exercise options and sell stock 12 months later in the following year
- Exercise options and sell stock one year and one day after exercise, but less than two years from the grant date.
- Exercise options and sell one year and one day from exercise, and more than two years after the grant date.
Unfortunately for employees, there’s no guarantee that the stock price will be higher than the strike price when the options vest or when the stock is sold. If the price is lower after the vesting period, the employee can hold onto the options until just prior to the agreed upon expiration date – usually 10 years after its original issue.
Before exercising ISOs it is important to consult a tax professional so there are no tax surprises.
Restricted Stock Units (RSUs) – (GSUs in the case of Google)
Restricted Stock Units, or RSUs, can be issued to an employee in the form of company shares issued through a vesting plan as part of compensation or bonus. RSUs give employees interest in company stock but have no tangible value and cannot be sold until they have vested. The vesting period of an RSU grant can occur monthly, quarterly or annually over several years.
RSUs give an employee an incentive to stay with a company long term and help it perform well so that their shares increase in value. As the RSUs vest, the stock is assigned a fair market value and a portion of the vested stock shares are sold to cover taxes for compensation. This appears on your W-2. The remaining vested shares are then available for the employee to hold or sell.
Gains on shares sold prior to one year and one day after vesting will be taxed as short-term capital or income tax rates, shares sold after will receive lower long-term capital gains tax treatment.
RSUs do not have voting rights until actual shares are issued to an employee at vesting. If an employee leaves before the conclusion of their vesting schedule, they forfeit the remaining shares to the company.
Employee Stock Purchase Plan (ESPP)
Some companies have an Employee Stock Purchase Plan, or ESPP, that allows employees to purchase stock at a discounted price through payroll deductions from the offering date to the purchase date. Funds are collected via payroll until the purchase date, when the company uses the money to buy stock on behalf of the employee at a stated discount.
The discounted rate for company shares can be as much as 15 percent lower than the current market value. ESPPs can utilize what’s known as a “look back provision” that uses a historical closing price of the stock that can be either the offering date price or the price on the purchase rate – whichever is lower.
An employee will owe income taxes on the difference between the price they paid (the discounted price) and the market value on the date of purchase. This taxable income may or may not show up on your W-2, irrespective, the employee must report the tax liability to the IRS. Stock from ESPP sold before the one year and one day time period will be taxable at short term capital gains or income tax rates. Stock held longer will be taxed at the more favorable long-term capital gains rate. Tax rules for ESPPs are similar to ISOs and can be very complex. It is important that you consult a tax professional before selling your ESPP shares any time before two years after the offering and one year after purchase.