United States
Hong KongStock options: ISO and NQSO, and the tax at each stage
A non-qualified option produces ordinary income on the bargain element at exercise. An incentive stock option produces no regular income at exercise but an AMT preference, and long-term treatment on sale if holding periods are met.
Two option types with completely different tax profiles, and a set of holding periods that decide which applies.
Non-qualified stock options
| Event | Tax |
|---|---|
| Grant | Generally none |
| Vesting | None |
| Exercise | Ordinary income on the bargain element; payroll tax applies |
| Sale | Capital gain or loss on the movement since exercise |
Straightforward, and the employer receives a deduction matching the employee's ordinary income. Basis after exercise is the market value at exercise. Basis resets at exercise.
Incentive stock options
| Event | Regular tax | AMT |
|---|---|---|
| Grant | None | None |
| Exercise | None | The bargain element is a preference item |
| Qualifying sale | Long-term capital gain on the whole gain | Adjustment on the AMT basis |
| Disqualifying sale | Ordinary income on the bargain element, capital treatment on the rest | No preference in the year of sale |
The advantage is capital gain treatment on the whole gain. The cost is the AMT exposure at exercise and the risk of holding a concentrated position for two years to get it.
The qualifying disposition holding periods
Two years from grant, and one year from exercise. Both. Both, not either.
Fail either and it is a disqualifying disposition: ordinary income on the bargain element, and no AMT preference for that year.
Exercising an ISO and holding creates a cash tax bill under AMT on a gain that has not been realized. If the shares then fall, the client owes tax on value that no longer exists. Model it before exercising, always.
The ISO limits
Only USD 100,000 of options, valued at grant, may first become exercisable in any calendar year and retain ISO treatment. The excess is treated as non-qualified.
ISOs can only be granted to employees, must be exercised within three months of leaving employment to retain treatment, and expire no more than ten years from grant.
Restricted stock and RSUs
Restricted stock is taxed as ordinary income when it vests, on the value at vesting. A section 83(b) election within thirty days of grant instead taxes the value at grant, starting the capital gain clock early.
The election is a bet: it pays if the shares appreciate, and the tax paid is not recoverable if they are forfeited. Restricted stock units generally cannot use the election, because there is no property transferred at grant. Thirty days, absolute.
The thirty-day window is absolute, which makes it a favorite exam detail.
Contribution and benefit limits are indexed annually and several were changed by recent legislation. Confirm the current figure against the IRS before relying on it.
Common questions
How are non-qualified stock options taxed?
Ordinary income on the bargain element at exercise, subject to payroll tax, with capital gain or loss on any movement between exercise and sale. The employer receives a matching deduction.
What are the ISO holding periods?
Two years from grant and one year from exercise. Both must be met for a qualifying disposition and long-term capital gain treatment on the whole gain.
What is the AMT problem with ISOs?
Exercising and holding creates no regular income but the bargain element is an AMT preference item, producing a cash tax bill on an unrealized gain that may later disappear.
What is the USD 100,000 ISO limit?
Only USD 100,000 of options, valued at grant, may first become exercisable in a calendar year and retain ISO treatment. The excess is treated as non-qualified.
What is a section 83(b) election?
An election within thirty days of a restricted stock grant to be taxed on the value at grant rather than at vesting, starting the capital gain clock early. The tax is not recoverable if the shares are forfeited.