Companies will offer stock options as equity compensation to attract employees, which can be valuable if we work for the next big company. Companies can offer two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). NSOs are usually only granted when ISOs are not available. Any employee, contractor, consultant, and board director can receive them.
As a refresher, our stock options are valuable if the current stock price (FMV) is higher than the strike price value of our stock options.
The spread will help us understand the different tax rates owed for an NSO.
NSO taxes on exercise
NSOs differ from ISOs because NSOs are taxed on exercise. When we exercise an NSO, we pay income taxes on the spread or the difference between the stock price and the strike price. Let's take a look at the chart below.
When we exercise our NSOs, the spread gets reported to the IRS as income regardless if we are able to sell our shares. The "income" we made will show up on our W-2.
NSO taxes on the sale
We will pay capital gains when we sell our NSOs. The gains are taxed as long or short-term capital gains depending on the length of time that passed since we exercised.
When NSOs seems like ISOs
Regularly exercising our NSOs will guarantee a tax bill; however, early exercising can make the taxes we owe seem like ISOs.
Some companies allow us to early exercise our options, meaning we can exercise all of our shares before they vest. If we exercise early, the stock price and the strike price will probably be the same. Since there isn't a difference, we wouldn't owe any taxes on exercise, and any future value would be taxed as capital gains.
Having a plan for exercising our NSOs helps prevent surprise tax bills. The lesson about NSO exercise and sales tax dives deeper into what to expect. Since NSOs have no preferred tax treatment, early exercising is even more important for this type of stock option. We can also read more in the lesson about early exercising.
We should also talk to a tax advisor if we're considering early exercising.