Stock Options (ISO vs. NQSO)

Stock options are a popular form of equity compensation that grant employees or other service providers the right to purchase company stock at a fixed price. For EA exam purposes, you must understand the critical tax differences between Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs).

Stock Option Fundamentals

Three key dates determine stock option taxation:

1. Grant Date – The date the employer grants the option to the employee
2. Exercise Date – The date the employee exercises the option (purchases the stock)
3. Sale Date – The date the employee sells the acquired stock

The exercise price (also called the strike price) is the predetermined price at which the option holder can purchase shares. The fair market value (FMV) is the stock's current market price. The bargain element (or spread) equals the FMV at exercise minus the exercise price—this difference is the source of taxable compensation.

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Incentive Stock Options (ISOs)

ISOs receive preferential tax treatment under IRC Section 422, but only if specific requirements are met.

Tax Treatment at Each Stage

At Grant: No tax consequences. The employee recognizes no income when ISOs are granted.

At Exercise: No regular income tax is due. However, the bargain element (FMV minus exercise price) is an adjustment for Alternative Minimum Tax (AMT) purposes. If you exercise ISOs but do not sell the shares in the same calendar year, you must add the spread to your income when calculating AMT.

At Sale (Qualifying Disposition): If holding period requirements are met, the entire gain from exercise price to sale price is taxed as long-term capital gain. The maximum long-term capital gains rate is 20% (plus 3.8% Net Investment Income Tax for high earners), compared to ordinary income rates up to 37%.

Qualifying Disposition Requirements

For a qualifying disposition, the employee must hold the ISO shares for:

• More than 2 years from the grant date, AND
• More than 1 year from the exercise date

Both conditions must be satisfied. The sale date must occur after the later of these two holding period deadlines.

Disqualifying Disposition

A disqualifying disposition occurs when shares are sold before meeting both holding period requirements. The tax consequences are:

• The lesser of (1) the bargain element at exercise or (2) the actual gain on sale is treated as ordinary income
• Any remaining gain is treated as capital gain (short-term or long-term depending on holding period)
• If the stock is sold at a loss, no ordinary income is recognized

Example: Employee exercises ISO at $20 when FMV is $30 (bargain element = $10). If sold 6 months later at $35:

• Ordinary income = $10 (the bargain element, lesser than $15 total gain)
• Short-term capital gain = $5 ($35 sale - $30 FMV at exercise)

The $100,000 ISO Limit

Under IRC Section 422(d), the aggregate FMV of stock (determined at grant date) for ISOs that first become exercisable in any calendar year cannot exceed $100,000. This limit applies across all ISO plans from the same employer.

• ISOs become exercisable according to the vesting schedule
• FMV is measured at the grant date, not the exercise date
• Any amount exceeding $100,000 is automatically treated as an NQSO

Example: An employee receives ISOs for 10,000 shares at $15/share ($150,000 FMV). If 5,000 shares vest in Year 1 ($75,000) and 5,000 in Year 2 ($75,000), all qualify as ISOs. But if all 10,000 shares vest in Year 1, only $100,000 worth qualifies as ISOs, and the remaining $50,000 is treated as NQSOs.

Employer Tax Treatment for ISOs

• Qualifying disposition: The employer receives no tax deduction
• Disqualifying disposition: The employer may deduct the ordinary income amount the employee recognizes

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Non-Qualified Stock Options (NQSOs)

NQSOs are stock options that do not meet ISO requirements. They have simpler but less favorable tax treatment for employees.

Tax Treatment at Each Stage

At Grant: Generally no tax, unless the option has a readily ascertainable fair market value (rare for private company options).

At Exercise: The bargain element is taxed as ordinary income and reported on the employee's Form W-2 as compensation. This income is subject to:

• Federal income tax withholding
• Social Security tax (up to the wage base of $168,600 for 2024)
• Medicare tax (including 0.9% Additional Medicare Tax for wages over $200,000/$250,000)

At Sale: Any gain or loss from the FMV at exercise is treated as capital gain or loss:

• Short-term if held 1 year or less from exercise
• Long-term if held more than 1 year from exercise

Who Can Receive NQSOs

Unlike ISOs (employees only), NQSOs can be granted to:

• Employees
• Independent contractors and consultants
• Directors
• Advisors
• Other service providers

Employer Tax Treatment for NQSOs

The employer receives a tax deduction equal to the ordinary income the option holder recognizes at exercise. This deduction is taken in the employer's tax year that includes the end of the employee's tax year in which the income is recognized.

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ISO vs. NQSO Comparison

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Reporting Requirements

Form 3921 (ISO Exercise)

Corporations must file Form 3921 for each ISO exercise. The form reports:

• Grant date
• Exercise date
• Exercise price per share
• FMV per share at exercise
• Number of shares transferred

Filing deadlines for 2024 exercises:

• Furnish Copy B to employee: January 31, 2025
• File with IRS (paper): February 28, 2025
• File with IRS (electronic): March 31, 2025

Employers filing 10 or more information returns must file electronically.

Form 3922 (ESPP)

Form 3922 is used for Employee Stock Purchase Plan (ESPP) transfers, not ISOs. However, ESPPs share similar qualifying disposition rules with ISOs.

NQSO Reporting

NQSO exercises are reported on the employee's Form W-2:

• Box 1: Includes the bargain element as wages
• Box 12, Code V: May show NQSO income specifically

The employer must withhold income tax and FICA taxes on the compensation.

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AMT Considerations for ISOs

When an employee exercises ISOs and holds the shares past year-end, the bargain element creates an AMT preference item. The employee may owe AMT even though no regular tax is due.

AMT Exemption for 2024:

• Single filers: $85,700
• Married filing jointly: $133,300
• Phaseout begins at $609,350 (single) / $1,218,700 (MFJ)

If AMT is paid due to ISO exercise, the employee may claim an AMT credit in future years when regular tax exceeds AMT.

Strategy: Exercising ISOs and selling in the same calendar year avoids AMT because the spread is then taxed as regular income, not as an AMT adjustment.