Qualified vs Non-qualified Stock Options - Difference and Comparison

How Stock Options Work

Stock options are often used by a company to compensate current employees and to entice potential hires. Employee-type stock options (but non-qualified) can also be offered to non-employees, like suppliers, consultants, lawyers, and promoters, for services rendered. Stock options are call options on the common stock of a company, i.e., contracts between a company and its employees that give employees the right to buy a specific number of the company’s shares at a fixed price within a certain period of time. Employees hope to profit from exercising these options in the future when the stock price is higher.

The date on which options are awarded is called the grant date. The fair market value of the stock on the grant date is called the grant price. If this price is low, and if the value of the stock rises in the future, the recipient can exercise the option (exercise her right to buy the stock at the grant price).

This is where qualified and non-qualified stock options differ. With NQSOs, the recipient can immediately sell the stock she acquires by exercising the option. This is a "cashless exercise", because the recipient simply pockets the difference between the market price and the grant price. She does not have to put up any cash of her own. But with qualified stock options, the recipient must acquire the shares and hold them for at least one year. This means paying cash to buy the stock at the grant price. It also means higher risk because the value of the stock may go down during the one-year holding period.

Rules for Qualified Stock Options (Incentive Stock Options)

The IRS and SEC have placed some restrictions on qualified stock options because of the favorable tax treatment they receive. These include:

• The recipient must wait for at least one year after the grant date before she can exercise the options.
• The recipient must wait for at least one year after the exercise date before she can sell the stock.
• Only employees of the company can be recipients of qualified stock options issued by the company.
• Options expire after 10 years.
• The exercise price must equal or exceed the fair market value of the underlying stock at the time of grant.
• For employees who own 10% or more of the company, the exercise price must be at least 110% of the fair market value and options expire in 5 years from the time of the grant.
• Options are non-transferable except by will or by the laws of descent. The option cannot be exercised by anyone other than the option holder.
• The aggregate fair market value (determined as of the grant date) of stock bought by exercising ISOs that are exercisable for the first time cannot exceed $100,000 in a calendar year. To the extent it does, such options are treated as non-qualified stock options.

Tax Treatment

Why do people use qualified stock options in spite of these restrictions? The reason is favorable tax treatment afforded to gains from QSOs.

When non-qualified stock options are exercised, the gain is the difference between the market price (FMV or fair market value) on the date of exercise and the grant price. This is also known as bargain element. This gain is considered ordinary income and must be declared on the tax return for that year.

Now if the recipient immediately sells the stock after exercising, there are no further tax considerations. However, if the recipient holds the shares after exercising the options, the FMV on the exercise date becomes the purchase price or "cost basis" of the shares. Now if the shares are held for another year, any further gains are considered long-term capital gains. If shares are sold before that timeframe, any further gains (or losses) are counted towards ordinary income.

The biggest advantage of qualified stock options is the the bargain element is not considered ordinary income. In fact, other than for AMT (Alternative Minimum Tax), the exercise of stock options does not even have to be reported in the year if the stocks are not sold. No taxes are due when qualified stock options are exercised and shares are purchased at the grant price (even if the grant price is lower than the market value at the time of exercise).

When stocks are eventually sold (after a holding period of at least 1 year), the gains are considered long-term capital gains, which are taxed at a lower rate than ordinary income. If stocks are sold sooner than the 1-year hold, it's called a "disqualifying disposition,” which is then treated just like a non-qualified stock option.

Examples

It is possible that incentive stock options — even though they were qualified stock options when granted — do not "qualify" for tax-advantaged status. For example,

• If it was a "cashless exercise": The employee may choose to sell the shares immediately after exercising the options, thereby pocketing the difference between the market price and the grant (strike) price of the option. This allows the employee to not spend any of their own cash and also frees them of the risk that the stock price will go down after exercising.
• If the employee did not hold the stocks for 1 year after exercising the options.

It's useful to look at different examples to understand tax implications. Let's say an employee was awarded stock options on January 1, 2010 when the stock price was $5. Let's also assume that the employee's income is $100,000 and she is in the 28% marginal tax rate bracket for ordinary income. Now let's take a look at the different scenarios and calculate the tax implications.

Examples for tax implications of qualified and non-qualified stock options

Scenario 1 is the classic qualified stock option. No income is declared when options are exercised and no taxes are due in 2011. Stocks are held for over 1 year after purchase so all gains are taxed at the long-term capital gains tax rate of 15%.

Scenario 2 is an example of a disqualifying disposition even though the plan was a qualified stock option plan. The shares were not held for one year after exercise, so the tax benefits of a qualified ISO are not realized.

Scenario 1 and Scenario 2 under the non-qualified category represent the same situation when the grant was under a non-qualified stock option plan. When the options are exercised (2011), ordinary income is declared equal to the difference between the FMV on exercise date ($15) and the grant price ($5). In Scenario 1, the shares are purchased and held for more than one year. So the further gains ($22 - $15) are considered long term capital gains. In Scenario 2, shares are not held for more than one year. So the further gains are also considered ordinary income. Finally, scenario 3 is a special case of scenario 2 where the shares are sold immediately after they are acquired. This is a "cashless exercise" of the stock options and the entire profit is considered ordinary income.

This spreadsheet has examples similar to the ones above that show of how income will be reported on W2 statements and how capital gains will be reported, both short-term and long-term in various scenarios.

TurboTax has a good guide on this topic that has even more detailed scenarios and also discusses how the Alternative Minimum Tax (AMT) further complicates matters for qualified stock options.

Avoiding double taxation

When income from stock option exercises is reported on W2, you must be extra-careful to avoid double taxation on it. This is because the brokerage uses the wrong cost basis on the 1099-B that they issue to you.

1099-B is a statement issued by stock brokers listing all your stock transactions. They are split into short-term and long-term so they can be easily reported. In addition to sending you this information, your broker also sends it to the IRS. For each transaction, the 1099-B notes the cost basis (i.e., purchase price or cost of acquiring the shares + broker's commission) and proceeds (i.e., amount received when shares are sold). The difference between the two is the net gain (or loss).

Even though the bargain element (see definition above) is reported as income on your W2, the brokerage does not adjust your cost basis in the 1099-B. e.g. if your grant price was $10 and you exercise your options when the price is $30 then $20 will be reported on your W2. Like all W2 wages, income taxes and other applicable taxes like Social Security and Medicare will be withheld from this income. So you would expect that the broker's 1099-B lists the cost basis as $30 (+ a small commission) and the proceeds as $30.

Instead what you'll find is that the 1099-B will report the cost basis as $10 and proceeds as $30 and report a gain of $20 to the IRS. So when filing your tax return, you should adjust the cost basis and note that the basis reported by the brokerage is incorrect. This is very important, otherwise you end up paying tax on it twice. Further reading on this topic.

References

ncG1vNJzZmivp6x7pbXFn5ynZpOkunCwyJ%2BdnqqVo7Cme7CumKWhlp6ypavVrJaHp55ivraty6Kdop2UlKC1u8KkloiopJ68r78%3D