Employees with access to NSOs, RSUs, and ISOs should understand the key differences and similarities among these equity awards to make informed decisions about exercise, sale, and tax planning.
1. Overview and Key Differences
NSOs (Nonqualified Stock Options): These options allow you to purchase company stock at a set price. They are called “nonqualified” because they do not meet the requirements for special tax treatment under the Internal Revenue Code.
ISOs (Incentive Stock Options): ISOs are like NSOs but must meet strict requirements under IRC § 422 to qualify for favorable tax treatment. They are only available to employees.
RSUs (Restricted Stock Units): RSUs are a promise to deliver shares (or their cash equivalent) after certain vesting conditions are met. No purchase is required.
2. Taxation Timing and Amount
NSOs: No tax at grant. Upon exercise, the difference between the fair market value (FMV) and the exercise price (the “spread”) is taxed as ordinary income and subject to payroll taxes. This amount is reported on your Form W-2. When you sell the shares, any additional gain or loss is capital gain or loss, based on the difference between the sale price and your basis (exercise price plus income recognized at exercise).
ISOs: No tax at grant or exercise for regular tax purposes. However, the spread at exercise is an adjustment for alternative minimum tax (AMT) purposes. If you hold the shares at least one year after exercise and two years after grant, any gain on sale is long-term capital gain. If you sell before meeting these holding periods (a “disqualifying disposition”), the spread at exercise is taxed as ordinary income, and any additional gain is capital gain.
RSUs: No tax at grant. When RSUs vest and shares are delivered, the FMV of the shares is taxed as ordinary income and subject to payroll taxes. This is reported on your Form W-2. Any subsequent gain or loss on sale is capital gain or loss.
3. Form W-2 Reporting
NSOs: The spread at exercise is included in Box 1 (wages), Box 3 (Social Security wages, up to the wage base), and Box 5 (Medicare wages). It is also reported in Box 12 with code “V”.
ISOs: No income is reported on Form W-2 at exercise unless there is a disqualifying disposition, in which case the ordinary income portion is reported as wages.
RSUs: The value of shares delivered at vesting is included in Box 1, 3, and 5 as wages.
4. Recordkeeping
All Awards: Keep grant documents, vesting schedules, exercise confirmations, and brokerage statements. For ISOs, track grant and exercise dates to determine holding periods for favorable tax treatment. For NSOs and RSUs, retain records of income reported and basis in shares for capital gains calculations.
5. Exercise and Sale Strategies
NSOs: Consider exercising when you can afford the tax on the spread and expect future appreciation. Some exercise and sell immediately to cover taxes (“cashless exercise”), while others hold for potential long-term capital gains.
ISOs: If you can meet the holding periods, you may benefit from long-term capital gains rates. However, exercising ISOs can trigger AMT liability, so calculate potential AMT before exercising. If you sell before meeting the holding periods, part of the gain will be taxed as ordinary income.
RSUs: Since income is recognized at vesting, many sell shares immediately to cover taxes. If you hold shares post-vesting, future appreciation is taxed as capital gain.
6. Employment Termination Considerations
NSOs: Typically, you must exercise vested NSOs within a set period (often 90 days) after termination, or they expire. Unvested NSOs are usually forfeited.
ISOs: You generally have 3 months after termination to exercise vested ISOs and retain ISO status; otherwise, they convert to NSOs. Unvested ISOs are forfeited.
RSUs: Unvested RSUs are usually forfeited upon termination unless the plan provides otherwise. Vested but undelivered RSUs may be paid out, depending on plan terms.
7. Other Tax Planning Considerations
Section 83(b) Election: Not available for NSOs unless the option has a readily ascertainable FMV at grant (rare). Not available for RSUs but can be relevant for restricted stock awards (not RSUs).
Qualified Equity Grants: Certain employees of private companies may be able to defer income on qualified stock received from options or RSUs for up to 5 years, subject to strict requirements.
AMT for ISOs: Plan carefully to avoid unexpected AMT liability, especially if you exercise and hold ISOs in a rising market.
Conclusion
Choosing when to exercise or sell depends on your cash flow, tax situation, and market outlook. Always review your plan documents and consult a tax advisor for personalized advice, especially regarding AMT exposure for ISOs and the impact of employment termination on your awards.
Related Posts
