STOCK OPTIONS Introduction

The taxation of statutory vs. non-statutory stock options, each a modern employee benefit, can be confusing. To help explain stock options, an example will be used throughout the following discussion. At the end of the discussion, a list of frequently asked questions will appear. This list grows so please stop by often.

Bill, a financial analyst, went to work for a on January 1, 1994. For each year (12-month period) he worked, Bill would receive an option to purchase 50,000 shares of, at a penny ($.01) per share. Each option would expire 10 years later. The company's current stock value was ten cents ($.10) a share, but was not publicly traded. The options had no other restrictions. Three years after he commenced work, Public bought for $20/share.

Statutory options (which are governed by the Internal Revenue Code) receive favorable tax treatment. A statutory stock option plan is either an incentive stock option ("ISO") or an option granted under a company’s stock-purchase plan.

With either plan, generally, the employee suffers no tax consequences, either upon receipt or exercise, and the employer receives no deduction. If the option is exercised and the stock received is held for 12 months or more before it is sold, the employee usually has long-term capital gains (LTCG) and is taxed at a maximum of 20% federal. Under the stock-purchase plan, however, part of the gain may be taxed as ordinary income.

Incentive Stock Options

ISOs are granted by a corporation (or its parent or subsidiary) to an individual in connection with employment. The option price cannot be less than the Fair Market Value (FMV) of the optioned stock at the time the ISO is received and must be excercisable within 10 years from receipt. Also, the employee cannot already own more than 10% of all classes of stock, by vote or value, of the company or its parent and subsidiary companies.

Once an ISO is exercised, the employee is taxed at the LTCG rate on the stock, provided he or she does not sell the stock for at least: (1) two years after the option was granted; and (2) one year after exercising the option. These holding requirements are waived if the employee dies. Also, the FMV of stock subject to an exercisable ISO cannot exceed $100,000 in any one calendar year. Only ISOs that are vested count towards the $100,000 limit.

An employee must remain employed by the employer (its parent or subsidiary) from the time the option is granted until at least three months before exercise. Also, an employee has up to three months after termination of employment to exercise an ISO. For disabled employees, the post-termination period is extended to 12 months and is waived completely upon death.

Failure to meet these holding requirements causes the gain to be taxed as ordinary income, determined at the time the option was exercised. The gain is usually the value of the stock on date of exercise minus the option price. The company is entitled to a deduction at the time the employee recognizes the income from the premature disposition.

If Bill received an ISO, then he would need to wait until the following dates to receive Long Term Capital Gain treatment:

Date ISO Received

Date of Exercise

(on or before)

Date of Stock Sale LTCG treatment

(on or after)










For example, if Bill sold all his stock to Public on January 2, 1997 for $20/share (assuming he exercised his stock options upon receipt) , he’d receive LTCG treatment on 50,000 shares ($1,000,000) and 100,000 shares ($2,000,000) would be taxed as ordinary income.

Stock Purchase Plans

Under these plans, if the option price is not less than 85% of the stock’s FMV when acquired (at grant) or at the time of exercise, then, in general, the difference between the option price and the FMV of the stock at the time of the grant is taxed as ordinary income. For example, suppose Bill acquired options to purchase Start-Up’s stock valued at $10/share for $8.50/share. If he exercised his option then sold the stock at least 12 months later (and at least 24 months after grant) for $25/share, then $1.50/share would be taxed as ordinary income and the balance ($15/share) would be capital gains.

The option must be exercised within 27 months of grant. This period is extended to five years if the option price is at least 85% of the stock’s FMV when the option is actually exercised. Also, no employee may receive options for more than $25,000 of stock per year, calculated when the option is received. The employee cannot already own more than 5% of all classes of stock, by vote or value, of the company, or its parent and subsidiary companies. There are other statutory requirements similar to those of ISO’s.

Alternative Minimum Tax

When an ISO is exercised, the "spread" (the difference between the stock value and option price) is a positive "adjustment" under alternative minimum tax ("AMT") rules.

In Bill's situation, the value of's stock over the option price, $4,500, is a positive adjustment under AMT rules. Generally, a spread this small will not trigger the AMT. If, however,'s stock is increasing in value, Bill should consider exercising his stock options as soon as possible.

A Short-Hand Method to Avoid the AMT

Note: Use Form 1040 (regular tax) and Form 6351 (alternative minimum tax) to perform this calculation. Determine your regular tax (assume $20,000) and your alternative minimum tax (assume $15,000). Subtract the difference ($5,000) then divide the $5,000 by the AMT tax rate of 26% ($19,230). Divide the $19,230 by the spread (assume $10) = 1,932 shares may be exercised without triggering the AMT.

Regular Tax (Form 1040)


AMT (Form 6351)




Divide by AMT rate (26%)


Divide by Spread per share


Maximum Number of Shares that may be exercised without AMT




1. Option Grant Must be fair market value at date of grant; "good faith" valuation necessary. No tax requirement; state corporate law may govern. Accounting charge if below fair market value or granted to consultant.



2. Qualifications Must meet all requirements of IRC 422 at time of grant; must be granted under qualified ISO plan.



None; may require state corporate securities permit if issued under a plan.
3. Who is Eligible? Employees only. Employees, consultants, directors, other independent service providers.



4. Limitations (a) $100,000 first exercisable per year;(b) grant and plan both have 10-year term only; (c) more-than-10% shareholders subject to special limitations.



No tax limitations
5. Deductions None if optionee holds for ISO holding period; deduction for spread if optionee makes disqualifying early disposition.



Deduction for spread in year of exercise provided income included by optionee.
6. Withholding Obligation None Withhold at supplementary rates (income tax and FICA) at exercise by employee




Stock options are powerful incentives with potentially huge payoffs, provided the employee understands how his or her particular company plan works and the tax consequences. For start-ups, the non-statutory stock option with immediate vesting, is probably the best alternative. Be sure to exercise the option once the spread becomes taxable to you. To obtain the maximum capital gain with a favorable tax rate, you must hold the stock at least 12 months.

Statutory stock-option plans have advantages as well. There is no ordinary income tax element upon receipt or exercise, and the subsequent stock sale may offer advantageous LTCG treatment. With an ISO, carefully calculate the AMT consequences.



Table of ContentsClick-Here for tradersauction internet online auctions for selling and buying resold (used) and new trading and investment products and financial domain names

  1. What is a Non Qualfied Stock Option Plan?
  2. What is the difference between an ISO and NSO?
  3. What is the $100,000 limit for ISOs?
  4. What is an AMT Credit?
  5. What is a Disqualifying Disposition?

What is a Non Qualified Stock Option Plan?

A non-qualified stock option is a way for a company to compensate employees or service providers without paying cash.

Instead, the company grants the employee or service provider an option to purchase shares of stock at a fixed price. The price is about the amount the stock is trading for when the stock is publicly traded. When the stock isn't publicly traded, the company determines the value of a share of stock on the date the option is granted. The option typically lapses on a certain date.

The incentive to the employee or service provider is to participate in the potential increase in value of the stock without having to risk a cash investment.

Since this arrangement is a form of compensation, the employee or service provider generally must report ordinary income when the option is exercised. The amount of ordinary income is the excess of the fair market value of the shares received over the option price.

The company receives a tax deduction for this ordinary income element reported by the employee or service provider.

The reason these options are called "non-qualified" is they do not qualify for special treatment of another type of option, called "incentive stock options."

Incentive stock options are only available for employees and other restrictions apply for them. For regular tax purposes, incentive stock options have the advantage that no income is reported when the option is exercised and, if certain requirements are met, the entire gain when the stock is sold is taxed as long-term capital gains.

Back to Top

What is the difference between and ISO and NSO?

The principal advantage of an ISO is that it postpones tax on the holder's gain (exercise price versus sales price) until the option stock is sold; the tax on an NSO holder occurs upon exercise, measured by the difference between exercise price and fair value as of that time. This is a major distinction. The NSO holder has to come up with his tax money earlier in the process, provoking a potentially unacceptable investment risk unless he can sell immediately after exercise. However, he cannot sell publicly; that is, he must either hold for one year or sell at a stiff discount, unless he is able to register his stock for sale.

On exercise, the NSO holder owes tax on the difference between exercise price and fair market value—calculated without regard to the restriction which will lapse; that is, the inability to sell publicly for one year. Let us say the trading price of the stock is $10 and the exercise price is $6. Tax is owed on $4 of gain. The second major advantage of the ISO over the NSO is that the gain on sale is considered a long term capital gain if the stock is held for a year after exercise (and the sale succeeded the grant by two years).

Regarding NSOs, there is an distinct advantage to the company issuing the NSO. The company issuing the NSO can take an employee compensation deduction equal to the amount the employee must take as income (fair market value at exercise less exercise price) in the current year. For ISOs, no deduction is allowed by the corporation.

Back to Top

What is the $100,000 Limit for ISOs?

The limit applies to the options that vest in any given year. It doesn't apply to the amount of gain.. The amount is determined by looking at the fair market value of the stock at the time the option was granted., not at the time the option vests.

For example, let's suppose you receive an option to buy 30,000 shares of company X at the time when it is trading at $10 per share. The fair market value of the stock, determined at the time the option was granted, is $300,000. Does this mean you exceeded the $100,000 limit? It depends on the vesting schedule. Suppose the option becomes exercisable over a period of four years, 7,500 shares per year. Then you have $75,000 worth of options vesting each year. That's within the $100,000 limit (assuming no other options exist).

Now suppose you receive another option in the second year. This one is for 4,000 shares, and the entire option is exercisable in the second year. The stock is trading at $12.50, so that's the value we use in applying the $100,000 limit to this option. This puts you over the limit, as $75,000 plus $50,000 is over $100,000. The result is that $25,000 worth will be treated as nonqualified options.

Back to Top

What is an AMT Credit?

Some or all of your AMT liability will be eligible for use as a credit in future years. This credit can only be used in years when you do not pay AMT. It is called the AMT credit, but it reduces your regular tax, not your AMT. In the best case, the AMT credit will eventually permit you to recover all of the AMT you paid in the year you exercised your ISO. When that happens, the only effect of the AMT waa to make you pay tax sooner. But for various reasons, you can't count on being able to recover all of the AMT in later years.

Back to Top

What is a Disqualifying Disposition?

When you exercise your stock option but don't hold the stock long enough, you've made a disqualifying disposition.

To avoid a disqualifying disposition you have to hold the stock you acquired by exercising your ISO beyond the later of the following two dates.

  1.    One year after the date you exercised the ISO or
        Two years after the date your employer granted the ISO to you.

If you hold the stock long enough to satisfy this special holding period, then any gain or loss you have on a sale of the stock will be long-term capital gain or loss. You won't be required to report any compensation income from the exercise of your option. If you fail to satisfy the holding period requirements, your sale or other disposition of the stock is considered a disqualifying disposition. In this case, you have to report compensation income.

Back to Top

For more information on Stock Options, consult the tax experts at Maxwell Shmerler & Co.
Maxwell Shmerler & CO.
Copyright © 2000  [MSCO]. All rights reserved.
Revised: March 12, 2001 .