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Restricted Stock, ISOs & NQSOs

Tax Issues

NonQualified Stock Options (NQSO)

When you exercise the option, the difference between the option’s strike price and the current market price is considered ordinary income and will show up on your W-2.  Any further appreciate or depreciation in the stock from that point forward is treated normally (i.e., as if you had bought the stock at the market price when you excised the option).

Warning – It is highly recommended that, at a minimum, you immediately sell enough stock to pay for the incurred tax liability of exercising your option.  Otherwise, you risk having the stock plummet in value leaving you with a large tax liability with no way to pay for it (this happened to many people during the dot com bust).

Incentive Stock Options (ISO)

Unlike the NQSO, an ISO does not get taxed when the option is exercised, just when the resulting shares are sold.  If the shares are sold more than a year after they were bought and more than two years after the ISO was issued, then the gain (i.e., the current price minus the option strike price) will be treated as long term capital gains and is NOT added to your W-2. This gain is subject to the alternate minimum tax however which may reduce this benefit.

Warning – If those criteria are not met (i.e., sell too soon), then it will be taxed like an NQSO, except that the ordinary income is recognized at stock sale rather than option exercise.

Restricted Stock

When you receive restricted stock (i.e., stock which you are not allowed to sell until you are vested), you have two tax choices.

  1. Special Tax 83(b) election – report the restricted stock as ordinary income in the year the restricted stock is issued to you at the market value at issuance.  This has the advantage that all subsequent stock appreciation will only get taxed when you sell and will be taxed at capital gain rates.  Warning – If you never become vested in the stock or the stock price drops in value you will not get back the taxes you paid.
  2. No election – report the restricted stock as ordinary income in the year you become vested in the stock at its market value at vesting.  Warning – like with the NQSO, it is highly recommended that, at a minimum, you immediately sell enough stock to pay for the incurred tax liability.

Income Tax Implications Summary Table

Event NQO ISO RS RS – 83(b) election
Issue no no no ordinary
Vesting no no ordinary no
Exercise ordinary no n/a n/a
Sell capital gains capital gains/ordinary capital gains capital gains

Diversification Issues

As an executive for a large company or a founder of a start-up, you have invested a lot of yourself in the company.   And it is natural to feel the stock is undervalued in the marketplace and that its future prospects are quite good.  However, if a significant part of your net worth is tied up in a single company, you owe it to youself to consider hedging enough of that exposure to ensure your personal fortunes don’t drop below an acceptable level no matter what happens to the company.  And while diversification is much easier to achieve once you have vested in your stock, it is still possible to provide some hedging even before you are fully vested so don’t put it off.

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