Compensation packages often include stock options, which are used to reward, incentivize and retain key employees.

Accounting For Stock Sales - Capital Gains vs Earned Income

There are two types of stock options that can be granted — Qualified Stock Options, also called Incentive Stock Options ISO , and Non-Qualified Stock Options NQSO. The major difference between ISOs and NQSOs is their tax treatment. There is no income tax due upon the granting of ISOs and there is no income recognized when an ISO is exercised. This is a major benefit of ISOs when compared to NQSOs. However, alternative minimum tax AMT needs to be considered when exercising ISOs.

If the stock received through the exercise is sold at least one year after the exercise date and two years after the grant date, any gain resulting from its eventual sale is considered a capital gain.

Otherwise, the sale would be considered a disqualifying disposition and would generate ordinary income as opposed to capital gain income.

Non-Qualified Stock Options NQSOs. Similar to ISOs, there is no income tax effect when NQSOs are granted. However, when NQSOs are exercised, ordinary income, classified as compensation, will be recognized by the employee.

The ordinary income is equal to the spread between the fair market value on the date of the exercise and the exercise price. If the stock is sold within one year of exercise, any further gain or loss is considered short term capital gain or loss. If the stock is held for more than one year before it is sold, any further gain or loss is considered long term capital gain or loss. Employees may have the option to implement a cashless exercise. This is helpful when the employee does not have enough cash to exercise the options.

In a typical cashless exercise, the company or broker involved lends the employee money to pay for the exercise. A portion of the stock received through the exercise is then sold through the market in order to immediately repay the loan. This is not a taxable event at this point.

If the employee had sold the 1, shares on March 15, it would have resulted in a disqualifying disposition. If the employee from above had received NQSOs instead of ISOs, he would recognize income equal to the spread between the exercise price and the fair market value of the stock at the time of exercise in the year he exercises the NQSOs.

As mentioned previously, AMT needs to be considered if you are exercising ISOs. The spread between the exercise price and the fair market value of the stock at the time the ISO is exercised is treated as a tax preference item for AMT purposes. This could cause the employee to be subject to alternative minimum tax in the year of exercise.

Because of this basis adjustment, there would be a negative AMT adjustment upon disposition. This would generally also result in a minimum tax credit against regular tax in the year of disposition.

The Affordable Care Act imposes a net investment income tax on unearned income at a rate of 3.

As discussed, an employee does not recognize income when ISOs are exercised and therefore does not owe the 3. The capital gain on the sale of shares received as a result of exercising ISOs, however, is included in net investment income and is subject to the net investment income tax. In the case of a disqualifying disposition of ISO shares, the ordinary income recognized by the employee is compensation and is, therefore, not subject to the net investment income tax but is subject to the 0.

With NQSOs, the amount recognized as compensation income upon exercise is not subject to the net investment income tax, but is subject to the 0. Once the NQSO is exercised and the stocks are transferred to the employee, however, subsequent dividends and gain on disposition of the shares are subject to the net investment income tax.

As the above examples show, the employee with an ISO pays the least in taxes, assuming a disqualifying disposition does not occur. So the next time you are lucky enough to have a choice between an ISO and NQSO, you are armed with the knowledge to wisely choose what is exactly right for you. Mazars USA LLP is an independent member firm of Mazars Group.

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Stock Options — To Qualify or Not To Qualify Stock Options - To Qualify or Not To Qualify Compensation packages often include stock options, which are used to reward, incentivize and retain key employees. Incentive Stock Options ISOs There is no income tax due upon the granting of ISOs and there is no income recognized when an ISO is exercised.

Accounting For Stock Sales - Capital Gains vs Earned Income

In order to qualify as an ISO, the option must meet the following requirements: The option must be granted within 10 years from the date the plan is adopted or the date the plan is approved, whichever is earlier. The exercise price must equal or exceed the fair market value of the stock at the time of the grant. The option must not be exercisable after the expiration of 10 years from the date it is granted. The option can only be issued to employees of the company.

Non-Qualified Stock Options NQSOs Similar to ISOs, there is no income tax effect when NQSOs are granted. Not for Profit Real Estate. Sign up to receive Mazars USA The Ledger.