©2015, College for Financial Planning, all rights reserved.

Session 15ISOs and NSOs

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits

Session Details

Module 8

Chapter 4

LOs 8-5 Identify characteristics of incentive stock options (ISOs) and employee stock purchase plans (ESPPs).

8-6 Identify characteristics of nonqualified stock options (NSOs) and other types of incentive stock plans.

15-2

Nonqualified vs. Qualified Plans

Characteristic Qualified Plan Nonqualified Plan

Internal Revenue Code Requirements

Discrimination Plan may not discriminate Plan may discriminate

ERISA Requirements

All plans must satisfy ERISA and IRC requirements

Certain plans are partially exempt from ERISA

Tax Treatment

Employer deduction

Available in year of plan contribution

Available in year of employee taxation

Employee deferral Tax-deferred until plandistribution; rollovers allowed

Tax-deferred only if unfunded or funds are at risk; no rollovers

Fund earnings Earnings accrue tax-deferred until distribution

Earnings usually are currently taxable to employer

Distributions Taxed at ordinary rates;averaging may be available on lump sums

Taxed at ordinary rates; averaging not available on lump sums

15-3

“Stock” Plans

• Restricted stock• ISOs• ESPPs• NSOs• SARs• Phantom stock• Performance unit

or share plans• Junior stock

15-4

Incentive Stock Options (ISO)

Requirements• Can only be offered to employees

• Must be issued under a written plan approved by the stockholders of the corporation

• The option term and exercise period cannot exceed 10 years

• The option price must equal or exceed the FMV of the stock at the time of the grant1

• The options must expire no later than three months after employment is terminated

• The option can only be exercised by the option holder and cannot be transferred, except at the death of the option holder

• No more than $100,000 can be exercised in one year

1 If the employee owns more than 10% of the voting stock of the company,

the option price must be at least 110% of the FMV. 15-5

Tax Treatment of Incentive Stock Options

• No income tax is owed when the ISOs:o are granted ando are exercised

• The difference between grant and exercise price is AMT income in year of exercise (if stock is disposed of in same year as exercise, no AMT income)

• Income tax is owed when the stock purchased with the ISOs is sold

• How the gain will be taxed depends on whether the disposition is a “qualifying disposition” or a “disqualifying disposition”

15-6

$10

$15

$25

Price

Understanding Stock Option Terms

Time

Disposition date

Grant date Exercise date

Exercise price

FMV at exercise

Disposition price

15-7

Price

Holding Periods and Taxation of ISOs

Time

Disposition date

Grant date Exercise date

$10

$15

$25

Exercise price

FMV at exercise

Disposition price

2 years from grant

1 year from

exercise

15-8

Price

Taxation of ISO Disqualifying Disposition

Time

Disposition date

Grant date Exercise date

$10

$15

$25

Exercise price

FMV at exercise

Disposition price

Holding period requirement not met

Held less than 1 year – entire gain taxed as ordinary income

$5

$10

The tax treatment of a disqualifying disposition is the same as for an NQSO (except for FICA and withholding rules). Disqualifying dispositions generally do not have AMT ramifications.

15-9

Employee Stock Purchase Plans (ESPPs)

• $25,000 annual maximum• Shares can be sold at up to a 15%

discount• Same holding period requirement as ISOs

for capital gains treatment

15-10

Nonqualified Stock Options (NQSOs)

• Options can be given to both employees and non-employees

• Exercise price must equal or exceed FMV of stock at time of grant

• The company can set the requirements for exercising the options

• The company can determine the conditions under which the options are forfeited

• No holding period rules apply

15-11

Tax Treatment of NQSOs

• The options are not taxed when granted unless they have an ascertainable value

• Taxed as compensation (W-2 income) upon exercise of the option (bargain element)

• The employer receives a deduction for the amount taxed to the option holder

• Any change in value between the FMV at exercise and the disposition price is taxed as a long- or short-term capital gain or loss

15-12

Price

Taxation of Nonqualified Stock Options

Time

Disposition date

Grant date Exercise date

Exercise price

FMV at exercise

Disposition price

Compensation

Capital gains

$5

$10

$25

$10

$15

15-13

Stock Option Comparison (1)

The plan must: ISO NQSO

Be a written document Yes Yes

Declare the number of shares subject to grant Yes No

Declare employees or classes eligible Yes No

Obtain shareholder approval 12 months before or after adoption Yes No

15-14

Stock Option Comparison (2)

The options must: ISO NQSO

Be granted within 10 years of approval or adoption of plan Yes No

Be exercisable no later than 10 years after the grant (5 years for >10% owner) Yes No

Be exercisable at no less than FMV on date of grant (110% for >10% owner) Yes No

Be nontransferable Yes No

Be limited to no more than $100,000 a year in FMV of shares per year Yes No

15-15

Stock Option Comparison (3)

Recipient must meet holding period of: ISO NQSO

From date of grant 2 years None

From date of exercise 1 year None

Be an employee on date of grant Yes No

Exercise options within timeframe3 months following

terminationNo

15-16

Question 1

Rex works for Titan Industries, which is currently trading at $12 per share. The company awards him incentive stock options (ISOs) for 2,000 shares with an exercise price of $12. Rex exercises (but does not sell) the options three years later when the stock is trading at $45 per share. Which one of the following statements is correct?

a. Upon exercise, Rex will owe taxes (W-2 income) on $24,000(2,000 shares x $12 exercise price).

b. Upon exercise, Rex will owe taxes (W-2 income) on $66,000 ($33 difference on 2,000 shares—difference between the $45 current price and $12 grant price).

c. Upon exercise, Rex will be subject to AMT taxes of $45 per share.

d. Upon exercise, Rex will not owe any regular income taxes.

15-17

Question 2

Rex was also granted some nonqualified stock options (NSOs), with an exercise price of $15 per share (issued when the company stock was trading at $15 per share). His grant was for 4,000 shares, which he exercises (but does not sell) two years later when the stock is trading at $50 per share.

Which of the following statements is correct? a. Upon exercise, Rex will owe taxes (W-2 income and

payroll taxes) on $200,000 (4,000 shares x $50 per share).

b. Upon exercise, Rex will owe taxes (W-2 income and payroll taxes) on $140,000 ($35 difference on 4,000 shares – difference between the $50 current price and the $15 grant price).

c. Upon exercise, Rex will be subject to AMT taxes on $140,000.

d. Upon exercise, Rex will not owe any regular income taxes.

15-18

Multiple Choice DataJim Dandy, the CEO of Dandy Industries, was awarded the following stock options from his company:

During the current year, 2015, Jim has the following transactions with the stock options:

During the current year, Jim has the following transactions with the stock options:

Stock Option

Grant Date Type Grant Price # of shares

AA Mar 1, 2007 NSO $15 5,000

BB Feb 1, 2008 ISO $20 1,000

CC Oct 1, 2009 ISO $30 1,000

DD Aug 1, 2010 NSO $35 5,000

Stock Option Date Action

Number of Shares

Mkt Price on Action Date

AA Jan 1, 2015 Exercise 3,000 $77 BB Feb 1, 2015 Exercise 1,000 $78 BB Feb 1, 2015 Sold 1,000 $78 CC Mar 1, 2015 Exercise 1,000 $80 DD Apr 1, 2015 Exercise 2,000 $82 DD Oct 1, 2016 Sold 2,000 $85

15-19

Question 3

Which one of the following is correct regarding options AA for 2015? a. Jim has W-2 income, subject to payroll

taxes, of $186,000. b. Jim has a short-term capital gain of

$186,000. c. Jim has a long-term capital gain of

$186,000. d. Jim has no tax liability since the shares

were exercised but not sold.

15-20

Question 4

Which one of the following is correct regarding options BB for 2015? a. Jim has a short-term capital gain of

$58,000. b. Jim has a long-term capital gain of

$58,000. c. Jim’s sale is a disqualifying disposition,

and he has W-2 income of $58,000. d. Jim has AMT income in the amount of

$58,000.

15-21

Question 5

Which one of the following is correct regarding options CC for 2015? a. Jim has no tax liability since the shares

were exercised but not sold. b. Jim has a $50,000 long-term capital

gain since the shares have been held more than two years since the grant date.

c. Jim’s exercise is a disqualifying disposition, and he has W-2 income of $50,000.

d. Jim’s exercise will result in AMT income of $50,000. 15-22

Question 6

Which one of the following is correct regarding options DD for 2015? a. Upon exercise, Jim will have W-2

income of $94,000. b. Upon exercise, Jim will have W-2

income, with payroll taxes of $94,000. c. Upon exercise, Jim will not owe any

taxes since the shares have not been sold yet.

d. Upon exercise, Jim will have AMT income of $94,000, but no regular income taxation.

15-23

Question 7

Which one of the following is correct regarding options DD? a. Upon sale of the stock, Jim will have W-

2 income, with payroll taxes, of $100,000.

b. Upon sale of the stock, Jim will have W-2 income of $6,000.

c. Upon sale of the stock, Jim will have a long-term capital gain of $6,000.

d. Upon sale of the stock, Jim will have AMT income of $100,000. 15-24

Question 8

Which of the following statements are true? I. Upon exercise, W-2 income is reported, and

payroll taxes due, for NSOs.II. Upon exercise, W-2 income is reported for

ISOs.III. Upon exercise, AMT taxable income will be

created if the ISO is not sold by the end of the year.

IV. If an ISO is sold in the same year as exercised, there will not be any AMT income reported.a. I and III only b. II and III only c. I, III, and IV only d. II, III, and IV only

15-25

©2015, College for Financial Planning, all rights reserved.

Session 15End of Slides

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits