Employer Stock Plans
Beyond traditional retirement accounts, many employers offer stock-based compensation. Understanding the tax treatment of employee stock options and stock purchase plans is essential for advising clients who receive company equity.
Employee Stock Options
Stock options give employees the right to purchase company stock at a predetermined price (the exercise price or strike price). There are two types, and the tax treatment differs dramatically.
Incentive Stock Options (ISOs)
- Receive favorable tax treatment under Internal Revenue Code (IRC) Section 422
- No regular income tax at exercise. The spread (difference between exercise price and fair market value, or FMV) is not taxed as ordinary income when you exercise
- If holding period requirements are met (2 years from grant date AND 1 year from exercise date), gains are taxed at long-term capital gains rates
- Only available to employees (not contractors or directors)
- Exercise price must be at least fair market value on the grant date
Exam Tip: Gotchas
- The ISO spread at exercise is not subject to regular income tax but is an AMT preference item. If the exam asks about "income tax at exercise" for an ISO, the answer is no, but Alternative Minimum Tax (AMT) may apply.
Non-Qualified Stock Options (NQSOs)
- No special tax treatment: taxed as ordinary income on the spread at exercise (difference between exercise price and FMV on the exercise date)
- The employer gets a tax deduction equal to the amount the employee recognizes as income
- Can be granted to anyone: employees, contractors, directors, consultants
- No holding period requirements for favorable tax treatment (the spread is always ordinary income)
Exam Tip: Gotchas
- NQSOs give the employer a tax deduction; ISOs do not. The employer deduction for NQSOs equals the amount the employee recognizes as ordinary income.
- If ISO holding period requirements are not met (a "disqualifying disposition"), the gain is taxed as ordinary income, just like an NQSO.
ISO vs. NQSO Comparison
| Feature | ISO | NQSO |
|---|---|---|
| Tax at exercise | No regular income tax | Ordinary income on spread |
| AMT impact | Yes (preference item) | No |
| Capital gains treatment | Yes (if holding period met) | Only on post-exercise appreciation |
| Employer deduction | No | Yes (at exercise) |
| Who can receive | Employees only | Anyone |
Employee Stock Purchase Plans (ESPPs)
- Allow employees to purchase company stock at a discount (typically up to 15% below FMV)
- Qualified ESPPs under IRC Section 423: the discount is not taxed at purchase. Taxation occurs at disposition
- Must be available to all employees (with limited exclusions)
- Often use a lookback provision: the discount is applied to the lower of the stock price at the beginning or end of the offering period
Exam Tip: Gotchas
- The ESPP discount (up to 15%) is not taxed at purchase. Taxation is deferred until the employee sells the shares. This mirrors the ISO concept of deferred taxation.