Different Kinds of Stock Options and How to Plan Around Them
Updated: Apr 13
Warren Buffett once said, “Risk comes from not knowing what you’re doing.” One area that is confusing for many people is stock from an employer and how to plan around that stock. We will start with discussing the different types of stock options and move on to planning strategies that can be considered.
When you receive stock from your employer it is either a form of compensation or a benefit that you qualify for and have access to. Many people will lump all kinds of stock compensation into the category of stock options, but there are a few different kinds with different structures to know about when it comes to company stock. Below are 3 of the most common kinds of employer stock options and stock:
1) Incentive Stock Options (ISO)
Incentive stock options, or ISOs, are most commonly seen in smaller companies that are interested in providing incentives for their key employees to grow the company and maximize profitability. When someone receives an ISO, they have received a right to purchase the stock at a future date specified. There are some specific limitations around ISOs and they may trigger an AMT tax, but the following is a hypothetical example of how this stock option could work:
In this example someone could have received a 100 share ISO with a grant price of $5 per share. These are issued on January 15, 2022, they cannot be redeemed for 3 years, and they also expire in 10 years. If 4 years later, they decide to ask for the stock because it is now valued at $10 per share, they lock in the value owned by “exercising” the option and turning it into actual stock with a cost basis of the initial grant price. When they sell the stock in the future, the tax due is based on the growth from the grant price and the length held. If they hold the stock after they exercise the option for at least one year and do not sell the shares for at least two years from the initial grant date, they can possibly pay a more favorable long-term capital gains rate on the gains over the grant price. It is important to note that only the first $100,000 worth of ISOs granted can be exercised in a calendar year with favorable tax treatment. Amounts over $100,000 are treated as an NSO.
2) Non-Qualified Stock Options (NSO)
Non-qualified stock options, or NSOs, are also more common in smaller companies, but one of the differences between these and ISOs are that NSOs can be owned by anyone, whereas ISOs are typically owned by employees or people with a direct financial tie to the company. Just like when someone receives an ISO, they have received a right to purchase the stock at a future date specified. There are some overlaps and differences between how ISOs and NSOs are taxed, but the following is a hypothetical example of how this stock option could work:
In this example someone could have received a 100 share NSO with a grant price of $5 per share. These are issued on January 15, 2022, they cannot be redeemed for 3 years but they do not expire. If 4 years later, they decide to exercise the stock because it is now valued at $10 per share, they lock in the value owned and claim the tax from the grant. The 100 shares are granted at $5 per share equaling a $500 value. That $500 is now ordinary income for the person exercising the NSO. The taxability on selling in the future is the same as the ISO, however, the initial grant value is considered income now.
3) Restricted Stock Units (RSU)
Restricted stock units, or RSUs, are not so much a stock option but rather more specifically they are a restricted stock or a stock that’s been pledged. They are more commonly seen in larger companies that would like to set up golden handcuffs or parachutes for executives but can be used in smaller companies that are planning on going public. When someone receives an RSU, they have received a stock but do not take possession of the stock until the future vesting date. When the vesting occurs, the full value of the stock becomes ordinary income for the holder, and many companies withhold shares at this time to account for the taxation. Stock can typically be liquidated at this time or held on to and subject to normal capital gains tax rates with a cost basis of the vesting date.
For example, someone could have received 100 shares of their company stock in an annual RSU grant. There is a vesting schedule that says 25% of the grant amount vests annually. Next year, the holder of the shares will be granted another 100 shares, and taxed on the 25% from the original grant. Over time, these grants stack and after 5 years, the employee is receiving 100 RSUs, being taxed on 100 vesting RSUs, and if they were to leave, they would be leaving behind 250 RSUs. Here’s a chart that depicts what year 5 looks like.
There are a couple of interesting tax points around RSUs to note. First, someone who has RSUs may have the vesting occur after a time period, or it can be based on an event. For example, some RSUs are tied to initial public offerings (IPOs) where shares are vested upon that initial offering and then they can be sold on the open market.
Second, if the stock does go immediately down after vesting (such as right after an IPO), the stock can be sold for a loss and the owner can take a capital loss to help offset future taxes.
Third is that there are some specific IRS rules around RSUs. Once is the IRC Section 83(i) election. This is an election that allows for taxes to be deferred for up to five years after a stock vests. Similar is the IRC Section 83(b) election. This election is where someone asks the IRS to count the RSUs as ordinary income upon granting as opposed to the vesting date. Taxes have to be paid sooner, but if the stock grows significantly during the vesting period, the growth during that period can be realized under capital gains taxes instead of ordinary income.
At the end of the day, whether it’s ISOs, NSOs, or RSUs, stock is a good thing to have offered to you because it is highlighting that you are a valued member of the team. When approaching your stock situation, make sure you know what you have and how it works so you can take advantage of maximizing your benefit.
The opinions expressed here are those of and not necessarily Raymond James. Opinions are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. This material is being provided for information purposes only. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Examples are hypothetical and meant for illustrative purposes only. Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person's situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we do not provide advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.