Incentive Stock Options, Non Qualified Stock Options, Restricted Stocks

Employee Stock Options

The National Center for Employee Ownership (NCEO) estimates that about 14.6 million Americans hold stock options and that the plans account for at least several hundred billion dollars.

Incentive Stock Options –ISOs and Non Qualified Stock Options –NQSO
Stock Options gives an employee the right to buy a certain number of shares in the company at a fixed price for a certain number of years. The price at which the option is provided is called the "grant" price and is usually the market price at the time the options are granted. Employees who have been granted stock options hope that the share price will go up and that they will be able to "cash in" by exercising (purchasing) the stock at the lower grant price and then selling the stock at the current market price. There are two principal kinds of stock option programs, each with unique rules and tax consequences: non-qualified stock options and incentive stock options (ISOs). Employee stock options generally are issued in two forms.

Nonqualified Stock Options
Qualified, Or "Incentive," Stock Options –ISOs

To fully understand Employee Stock Options, you must embrace the following terminology as given to us by The National Center for Employee Ownership (NCEO)

“OptionSpeak”

Exercise: To elect to purchase stock pursuant to an option.
Exercise date: The date that an individual or an entity purchases stock pursuant to an option. Know the expiration date for your stock options. Once they expire, they have no value.
Exercise price: The price at which stock can be purchased pursuant to a stock option. Synonymous with "strike price."
Grant date: The date on which an option is first offered to an individual or entity.
Incentive stock option: An option, qualifying for favorable tax treatment under section 422 of the Internal Revenue Code (the "Code"), granted to an employee of a corporation to purchase company stock at a specified price for a specified period of time. Generally, there are no tax consequences until the stock is sold.
Nonqualified (nonstatutory) stock option: A stock option that does not qualify for favorable tax treatment under Code sections 422 or 423.
Qualified stock option: An option to purchase shares provided to an employee of the corporation under terms that qualify the option for special tax treatment under sections 422 or 423 of the Code. Synonymous with "statutory stock option."
Restricted stock option or restricted stock: An incentive or nonqualified stock option or stock that is subject to certain restrictions imposed by the employer; for example, employees may be required to sell their stock back to the employer upon termination of employment at the price they paid for the stock.
Section 423 stock purchase plan (sometimes called an "employee stock purchase plan" or ESPP): A plan under which a company allows employees to purchase stock at up to a 15% discount; purchasers receive favorable tax treatment if the plan meets certain rules.
Strike or striking price: Price at which an option (e.g., to purchase stock) is exercised. The price at which named stock can be put or called is ordinarily the fair market value when the option is written and is termed the "striking price." Synonymous with "exercise price."

How to Exercise Your Stock Options
Once you decide the time is right to exercise your options, there are several alternatives you can use to exercise your stock options.

You can use cash
You can take out a loan (hopefully at a very competitive)
You can use your existing company stock to swap for the options.

Cash
You can choose to purchase the options using your own cash. In that case, your primary decision is whether or not to hold or sell all or a portion of the stock.

Borrow
Generally, the firm holding your options would temporarily extends credit in order to initiate an option exercise. The amount borrowed is enough cash to exercise your stock options and then sell enough of the resulting stock to cover the amount borrowed, along with any accrued interest or fees. The complete process of exercising stock options can take one to two weeks, primarily due to the time it may take a transfer agent to deliver the shares.

Use Existing Company Stock To Swap For The Options

Exercise-and-Sell-to-Cover Transaction
Exercise your stock options to buy shares of your company stock, then sell just enough of the company shares (at the same time) to cover the stock option cost, taxes, and brokerage commissions and fees. The proceeds you receive from an exercise-and-sell-to-cover transaction will be shares of stock. You may receive a small residual amount in cash.

The advantages of this approach are:

benefits of stock ownership in your company, (including any dividends)
potential appreciation of the price of your company's common stock.
the ability to cover the stock option cost, taxes and brokerage commissions and any fees with proceeds from the sale.

Exercise-and-Sell Transaction (Cashless)
Using this strategy may require a margin account. You may exercise your stock option to buy your company stock and sell the acquired shares at the same time without using your own cash. The proceeds you receive from an exercise-and-sell transaction are equal to the fair market value of the stock minus the grant price and required tax withholding and brokerage commission and any fees.

The advantages of this approach are:

Cash (the proceeds from your exercise minus fees and commissions)

Taxation of Stock Options

Nonqualified Stock Options
When you exercise a Nonqualified Stock Options –NQSO, the spread between your exercise price and the market price is your profit. Your profit is generally taxed at ordinary income rates in that year's tax return. After you exercise the option, of course, you own the stock and your new tax basis is the market price on the exercise date. The company generally receive a tax deduction on the “spread”.

Options are taxed when unrestricted property rights vest or when the restrictions on the enjoyment of the property lapse. Keep in mind that the option (as opposed to the stock it may eventually allow one to buy) has a value independent of the stock. The difference between Sara 's option price and the FMV of the Great Company Inc stock can be taxed before the restrictions lapse.

Suppose that, in 2008, Sara is given an option to purchase stock in Great Company Inc when the stock has a FMV of $100 per share while the exercise price of the option is $45. If the option itself has no readily ascertainable" fair market value –RAFMV…the grant of the option will not be taxable. If the option has a readily ascertainable FMV (for example, it's publicly traded), the $55 difference could be taxable income to Sara and subject to withholding taxes in 2008.

Incentive Stock Options
Incentive Stock Options –ISOs qualify for special tax treatment. Gains are generally taxed at capital gains rates instead of higher, ordinary income rates. The company does not receive a tax deduction for this type of option.

Why Are Incentive Stock Options –ISO More Favorable? Turbo Tax

Simply stated…Non-Qualified Stock Options – NQSO's are taxed at ordinary income rate. Your Incentive stock options are taxes at 15%.
Incentive stock options are one of the most popular types of incentives used by companies to attract and keep executives. In most cases, these options provide more favorable tax treatment than non-qualified stock options, which are generally given to rank-and-file employees.
The advantage of an ISO is you do not have to report income when you receive a stock option grant or when you exercise that option. You only need to report the taxable income when you sell the stock. And, depending on how long you own the stock, that income could be taxed at capital gain rates of 15 percent or less -- a lot lower than your regular income tax rate.
With ISOs, your taxes depend on the dates of the transactions (that is, when you exercise the options to buy the stock and when you sell the stock). The price break between your grant price you pay and the fair market value on the day you exercised the options to buy the stock is known as the bargain element.

How Transactions Affect Your Taxes
Incentive Stock Option transactions fall into five possible categories, each of which may get taxed a little differently. You can:

Exercise your option to purchase the shares and hold them.
Exercise your option to purchase the shares, then sell the shares the same day or within the same year. (disqualifying disposition)
Sell shares less than a year after you purchased them. (disqualifying disposition)
Sell shares at least one year and a day after you purchased them, but less than two years since your original grant date. (disqualifying disposition)
Sell shares at least one year and a day after you purchased them, and at least two years since the original grant date.

Each transaction has different tax implications. The first and last are the most favorable; the middle three are the least favorable. The time at which you sell determines how the proceeds are taxed.

If you can wait at least a year and a day after you purchase the stocks, and at least two years after you were granted the option, any profit on the sale -- the difference between the bargain price you paid for the stock and what you sold it for -- is treated as a long term capital gain, so it is taxed at a lower rate than your regular income. This is the most favorable tax treatment, because long term capital gains are taxed at a maximum 15% (or as low as 5% or if you're in the 10% or 15% income tax bracket) compared to ordinary income tax rates which may be as high as 35%. Starting in 2008 and running through 2010, taxpayers in the two lowest income tax brackets will pay no tax on long-term capital gains and qualified dividends.

Sales that meet these one- and two-year time limits are called "qualifying dispositions" because they qualify for favorable tax treatment. No compensation is reported to you on your Form W-2, so you do not have to pay taxes on the transaction as ordinary income at your regular tax rate. Category 5 is also a qualifying disposition.

How Disqualifying Events Are Handled
Unfortunately, if you sell the stocks before they meet the criteria for favorable capital gains treatment, the sales are considered "disqualifying dispositions," and you may end up paying taxes on part of the proceeds of the sale at your ordinary income tax rate, which could be as high as 35%. When you sell the stock two years or less from the offering date, known as the grant date, or one year or less from the exercise date, which is when you purchase the stock, the transaction is a disqualifying disposition. In that case, that compensation should be reported on your Form W-2. The reported amount is the bargain element, which is the difference between what you paid for the stock and its fair market value on the day on the day you bought it. But if your bargain element is more than your actual gain from the sale of the stock, then you report your compensation as the lesser amount of the actual gain. The reported compensation is taxed as ordinary income. (Categories 2, 3, and 4 are disqualifying dispositions).

Restricted Stock
This stock is not vested. Generally you aren't treated as the owner for tax purposes until the stock vests. You may have ownership rights for the stock even though the tax law doesn't treat you as an owner. For example, unless you've agreed otherwise you're entitled to vote the stock you receive as an award even if it isn't vested.

Section 83b Election
You don't have to pay tax at the time you receive stock that's not vested. But the amount of tax you pay later when it vests can be significantly higher. You report income when the stock vests, even if you don't sell it at that time. Important! During the period you're waiting for your stock to vest, any increase in the value of the stock is going to result in ordinary compensation income, not capital gain. You have to report the full value as compensation income, not capital gain. If you think you would be better off under the rules for vested stock, you can elect to use those rules, (You can use Section 83b Election). It you use a Section 83b Election… you have to file the election within 30 days after receiving the stock.

Basis And Holding Period
For the period before the stock vests, your basis is equal to the amount you paid for it, if any. In other words, if you didn't pay anything for the stock, your basis is zero. After the stock vests, your basis includes the amount you reported as income when the stock vested (in addition to the amount you paid for the stock, if any).

When Section 83b Election Does Not Make Sense

If the stock doesn't rise in value after you make the election, you've accelerated tax (paid it sooner) without receiving any benefit.
If you forfeit the stock after making the election. In this case you would deduct any amount you actually paid for the stock (subject to capital loss limitations) but you get no deduction relative to the compensation income you reported when you made the election. That's a miserable result: the election caused you to pay tax on income you didn't get to keep, with no offsetting tax benefit later on.

When Section 83b Election Does Make Sense
Under Internal Revenue Code section 83(b), you can make a timely election to maximize the amounts taxable at long-term capital gain rates and, in the case of an ISO, minimize the alternative minimum tax. A smaller (or non-existent) bargain element, such as may be present before your company goes public may make the election even more attractive.
If you make the Section 83b Election, the election must be made within 30 days after you receive the stock.

Tax Expert: Kaye Thomas, graduate of Harvard Law School and member of the Harvard Law Review gives this advice. The section 83b election makes sense in the following situations:

The amount of income you'll report when you make the election is small and the potential growth in value of the stock is great.
You expect reasonable growth in the value of the stock and the likelihood of a forfeiture is very small. Conversely, you should avoid the section 83b election where a forfeiture seems likely, or where you'll pay a great deal of tax at the time of the election with only modest prospects for growth in the value of the stock.
Sometimes an employee pays full value for stock in the company, but has to accept a risk of forfeiture. The way this usually works is the employee agrees to sell the stock back for the amount he paid to buy it if he quits within a specified period. This is a risk of forfeiture even though the employee won't lose his original investment because he can lose part of the value of his stock if employment terminates before a specified date. As a result, the employee will recognize income when the stock vests. You can avoid this result by making the section 83b election. And it's free. The election costs nothing because the amount of income you report is the value of the stock minus the amount you paid, and that's zero. Failure to make this free election can be a costly mistake.

Preparing To Take The Section 83b Election
There's no special form to use in making the election. You simply put the appropriate information on a piece of paper and send copies to the right people. The paper should say "Section 83b Election" at the top and begin with the words, "The taxpayer hereby elects under Section 83b as follows." Then provide the following information:

Your name, address and social security number.
A description of the property (for example, 80 shares common stock of XYZ Corp.).
The date you received the property and the taxable year for which you're making the election. (Unless you're one of the lonely few who have a fiscal year, you're making the election for the calendar year in which you received the property.)
The nature of the restriction(s) on the property (for example, "forfeit if employment terminates before July 31, 1999").
The fair market value at the time you received the stock. Note that for this purpose you can't use the possibility of a forfeiture or any other non-permanent restriction to reduce the value.
The amount, if any, you paid for the stock.
A statement as follows: "I have provided copies of this statement as required in the regulation."
Filing the election

The key point about filing the election has already been mentioned: it has to be made within 30 days after you receive the property. If you don't act within that time you're out of luck. Here's what you need to do:

Within 30 days after you receive the stock, send the election to the IRS office where you file your return. (Check the instructions to Form 1040 if you're not sure of the address.) We highly recommend sending this election by certified mail and getting a stamped receipt with a legible date.
Provide a copy of the election to your employer (the company that granted the stock)
In the unusual situation where you had your employer transfer the stock to someone other than yourself, you need to provide a copy to that person as well.
Attach a copy of the election when you file your income tax return for that year.

Exercise The ISOs Sooner Rather Than Later ( Smart Money)
Exercising a large incentive stock option is almost certain to cause you to pay alternative minimum tax unless you sell the stock within the same year. If you expect your company stock to rise steadily, exercising your ISOs shortly after vesting may keep you out of the Alternative Minimum Tax trap. Here’s why… The AMT income is increased by the "spread" between market value at the time of exercise and the exercise price. For example, if Sara’s ISO gave her the right to buy 500 shares at $40, exercising when the stock is trading at $50 creates a spread of $5,000 ($10 per share times 500 shares). But exercising sooner i.e. when the market price is only $44 would minimizes the spread. A lower spread means less chance Sara would be caught in the Alternative Minimum Tax trap.

Stagger Your Exercise Dates Over Several Years
If your stock has already risen substantially and assuming your ISO doesn't expire before the year's end, you could do a partial exercise this year and defer exercising the rest until later. Again, this minimizes the spread in any one year and increases your odds of dodging the AMT.

Good and Bad…The Future Is Never Certain
Of course if the stock keeps rising, this strategy can backfire because the spread in future years will keep getting bigger and bigger. However, even if the stock keeps going up you might not just be postponing the inevitable by staggering your exercise dates. Congress could decide to liberalize the AMT rules, which could reduce your risk of owing the tax in future years when you will be exercising your remaining ISOs.

Reference Notes

A Word On Captial Gain Rates
There are several long-term capital gains tax rates. The 15% maximum capital gains tax rate applies to sales of assets held for more than 12 months (0% for those in the 15% or lower tax bracket for 2008 to 2010). The 28% rate applies to depreciation recapture for certain real estate. Source - Tax Strategies: Capital Gains and Losses

Reduction in Capital Gains Tax Rates for 2008 to 2010
Prior to 2008, long-term capital gains from the sale of assets held longer than one year were taxed at a maximum rate of five percent to the extent the seller was in the 10 or 15 percent tax brackets. In 2008, the five percent maximum rate drops to zero percent through 2010. The 15 percent maximum tax rate on other long-term capital gains stays the same.

Starting in 2011….Business As Usual (Turbo Tax)

Estate Tax Revived. For individuals dying after 2010, the federal estate tax returns with a $1,000,000 exemption and a 50 percent maximum rate.
Increase in Capital Gains and Dividend Tax Rates. The tax rate reductions for long-term capital gains and dividends expire this year.
In 2011, the maximum long-term capital gains tax rate goes back up to 20 percent from 15 percent. A lower 10 percent tax rate is used by individuals to the extent that they are in the 10 percent and 15 percent tax brackets. Their long-term capital gains had been tax free since 2008.
In 2011, dividend income (other than capital gain distributions from mutual funds) is taxed as ordinary income at the taxpayer's highest marginal tax rate.

Alternative Minimum Tax (AMT) – AMT is an extra tax you pay in addition to the regular income tax. The amount of AMT you pay depends on whether you have tax preference items or certain types of deductions. The exercise of an ISO can trigger AMT. The spread between the option price and market value on the date of exercise is considered a tax preference item for purposes of calculating AMT. If you pay AMT in the year you exercise your ISO, you can receive a credit against your regular tax in future years. This avoids a "double tax" on the sale of your stock. However, the amount of credit you receive in future years depends on your individual circumstances and many people never fully recover the AMT.

In some circumstances, AMT is primarily a prepayment of tax which is recovered at the time you sell your shares or in other future years. You can reduce the amount of AMT by doing some tax planning with respect to the items which impact AMT. The most effective way to minimize AMT is to have multiple year tax projections prepared using tax planning software to run various scenarios.

The Alternative Minimum Tax Factor

Incentive Stock Options
There is a catch with incentive stock options, however: you do have to report the bargain element as taxable compensation for Alternative Minimum Tax –AMT purposes when you exercise the options (unless you sell the stock in the same year).

Non-Qualified Stock Options
With non-qualified stock options, you report the price break as taxable compensation in the year you exercise your options, and it's taxed at your regular income tax rate.

National Center for Employee Ownership –NCEO
The National Center for Employee Ownership (NCEO) is a private, nonprofit membership and research organization that serves as the leading source of accurate, unbiased information on employee stock ownership plans (ESOPs), equity compensation plans such as stock options, and ownership culture. NCEO