Over the past several years, we have seen many varieties of equity compensation structures for both C-level executives and key employees at some of the most well-known and successful companies on the West Coast. The Companies we work with include those who have been publically-traded for a time, and those who have recently gone IPO or are getting close to an IPO. In all situations, there are immense opportunities for planning and strategy around minimizing tax liabilities on an annual basis.
- Non-Qualified Options (NSO’s or NQSO’s)
NQ stock options are granted, often subject to a vesting schedule. Under section 409(a) of the Internal Revenue Code, the FMV on date of grant is added to ordinary income if there is an ascertainable FMV (publicly-traded) unless there is a substantial risk of forfeiture.
The difference between the option price and the fair market value for a company that isn’t publically traded is added to income upon exercise and not at grant. The price of the option for a company that isn’t publically-traded is determined by the company, generally with the involvement of a third-party to ensure proper 409(a) compliance.
It is a bit more complicated in certain scenarios under 409(a) – we will cover that in our next post.
As mentioned, when the holder of the option exercises the option, the difference at the time of exercise is ordinary income, subject to income taxes and self employment taxes and is reported as either W-2 wage income to an employee or 1099 income to a non-employee.
Another unique characteristic is that NSO’s can be granted to non-employees, which is not the case with ISO’s. Often times, companies will use NSO’s as a way to compensate advisors or consultants in the early stages of the company as an incentive because they cannot use ISO’s.
Stock Sales – When selling the stock, it may be in your best interest to hold the stock for one year from the exercise date to preserve long-term capital gain treatment. This could be significant as there are still long-term capital gains at 15% (depending on your effective tax bracket – they can be 20%+NIIT or 23.8%) whereas ordinary income rates are up to 39.6% federally. If you don’t meet the holding requirements, the gain on the sale will be ordinary income.