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There's A Time And Place For Nonqualified Options

When it comes to employee stock options, many executives are familiar with incentive stock options (ISOs), also known as qualified stock options. ISOs are often popular with corporate higher-ups because of the preferential tax treatment the options can provide if certain requirements are met. In contrast, nonqualified options (NQOs) largely have managed to fly under the radar. But this other type of employee stock option can offer several advantages .

With either type of option, employees are granted the right to purchase company stock at a fixed price after a specified period of time. The presumed benefit is that the market price of the shares will have risen to a higher value by the time the employee is able to exercise the option. If that’s the case, the employee can buy the stock for less than its current market price.

However, there are several key distinctions between the two types of options. With ISOs, the exercise price of the option must equal the stock’s fair market value at the time the option is granted. In addition, ISOs are loaded with lots of other restrictions concerning how, when, and to whom the options may be granted. On the plus side, the employee won’t realize any taxable income from ISOs until the stock is sold. Even then, if rules for holding periods are met, any gain may qualify as a long-term capital gain and be taxed at a favorable rate.

NQOs operate under a different set of tax rules. Significantly, you must pay tax at ordinary income rates in the year you exercise the option, rather than in the year you sell the stock. As with an ISO, you will recognize tax consequences from any subsequent sale of stock after you exercise the option. However, if your company grants you NQOs, it can claim a deduction for their value in the tax year in which you recognize income from the options. ISOs are not tax deductible.

Let’s assume you work for a public company that issues NQOs to executives, but the options themselves aren’t traded on any major exchange. When you exercise an option to purchase stock, you owe tax on the discount known as the “compensation element.” That’s the difference between the exercise price established under the option agreement and the market price of the stock on the day you exercise the option to buy the stock. You can average out the high and low prices of stock trades on that day.

For example, suppose stock in your company is currently trading at $10 a share. Your company grants you an NQO that allows you to exercise 1,000 shares of stock at $12 a share. When the price of your company stock reaches $20 a share, you decide to exercise your option. Thus, your taxable income in the year of the exercise is $8,000 (market price of $20/share minus exercise price of $12 a share x 1,000 shares).

Suppose you hold the stock for a while and then sell your 1,000 shares at $30 a share. Because your basis is $20 a share (although you paid only $12), you owe tax on a gain of $10,000 ($30/share minus $20/share x 1,000 shares). If you’ve owned the stock for a year or less, the gain is treated as a short-term gain and is taxed at ordinary income rates. Currently, the top marginal tax rate is 39.6%. But if you hold the shares for more than one year, the gain will be taxed at long-term capital gain rates. The maximum tax rate is 15%, but it increases to 20% for certain high-income investors.

To further complicate matters, some high-income people may owe an additional 3.8% Medicare surtax on a portion of their investment income.

Remember that your company must report the compensation element as wages on your Form W-2 in the year you exercise the options. This means the IRS will know all about your good fortune. You’ll also be hit with federal payroll taxes on the compensation element.

Finally, be aware that NQOs may offer greater flexibility than ISOs. For instance, you might transfer the options to low-taxed family members, such as your children, before you exercise them. Then your children will be taxed at their low rates on the compensation element. You can’t do that with ISOs, which normally can’t be transferred. Consult with your financial and tax advisors regarding this idea and other tax planning opportunities.