Employee stock options are a staple of startup compensation packages. Many companies default to granting Incentive Stock Options (ISOs) instead of Nonqualified Stock Options (NSOs), perhaps because the word “incentive” sounds like there should be goodness associated with it.
After the dot-com bubble burst in 2000, many option holders and financial advisers experienced the pitfalls of attempting to capture the presumed goodness of ISO benefits firsthand.
The main benefit of ISOs is favorable tax treatment. If an employee holding an ISO exercises it and then holds the stock for more than a year after exercise, and more than two years after the employer granted it, the employee gets capital gains tax treatment on the difference between the strike price and the selling price. That could mean as much as a ten percent tax cut. Sounds magical, right?
The problem is that if the stock goes down, you’ve already paid the tax, you have a high basis and you can never get that money back. This is in fact what financially destroyed many people that tried to hold stock in early 2000 and why almost no one today holds an ISO in order to qualify for the incentive.
Since 2000, the situation has only gotten worse. In addition to jumping through the holding period hoops, anyone who is exercising a meaningful amount of stock options will be subject to alternative minimum tax (AMT). For the purposes of AMT, ISOs are a preference item. So in all likelihood, you’re going to get taxed on that difference at the time of exercise anyway, not when you sell the stock.
That being the case, for the employee, that one-year holding period is just too risky. You’ve written a check to the company, you’ve paid AMT, and you’re holding on for dear life hoping that the stock hangs together. And, you’ve probably got too much exposure to that one stock. It’s a bet people should not be making. In most situations, financial advisers would recommend against it. In fact, back at the time the bubble burst Congress had to pass a bunch of laws to try to help people who had paid millions of dollars to IRS in taxes for gains on stock that turned out to be worthless.
There are some limited situations at the extremes of the income scale where ISOs could have some potential benefit. People with low compensation, particularly in low or no-tax states might not be subject to AMT. At the other extreme, highly paid executives who are exercising a huge amount of stock and pushing themselves beyond AMT because their income is so high might be able to retain a small amount of options that would qualify for ISO without triggering AMT. Even then, I venture that most financial advisers are going to counsel against holding a concentrated position in a single stock, and rolling the dice not only on the stock price but on the tax code staying the same until you can sell.
You can’t count on the stock going up, and you can’t count on taxes staying the same, so most people exercise their stock and then sell it immediately. So, there’s rarely a tax incentive in ISOs.
On top of that, ISOs can create a record keeping headache for finance. Here’s why: With ISOs, the company gets a deduction if the employee has a non-qualifying disposition, i.e. when the employee sells the stock without holding it for the required year.
That does not sound like a bad thing, but to get the deduction the company has to know when the employee sells the stock. But, once someone has moved their stock out of the employer-designated brokerage account, there’s no reliable way to do that. What most companies do is send you a letter and ask you out the kindness of your heart, would you please inform them did you sell this stock, and when and for how much?
The employee is under no obligation to respond. If I were handicapping, I’d say there’s a 50% chance the company will get that information, so the company loses about half of what could be a big tax deduction. ISOs offer no tax benefit to the employee, only a tax cost to the company, plus the administrative cost of tracking and trying to find information.
The alternative is the Non-qualified Stock Option, or NSO. The moment an NSO is exercised, it’s a taxable event for the employee and it’s an immediate tax deduction for the employer. Since it runs through payroll, the employer knows about it and there are no issues around documenting the deduction. It’s very clean.
For the finance administrator or corporate executive that’s really interested in using stock options to attract and retain talent, it’s important to understand the difference between these two instruments when deciding which type of options to issue.
Many companies, especially those with CFOs who have never had to contend with a company going–or being–public continue to grant ISOs. NSOs are the better option in most cases. If your company aspires to go public, or already is public and just wants to make life easier for everyone, they should switch to offering NSOs moving forward.