ISO Love Stock Options

Editor's Note: Today's post comes to us courtesy of guest contributor Judy Freides.

As the candidates pursue the Republican nomination, there is a lot of discussion around tax reform. Some of the changes being put on the table could influence companies’ stock option practices.

In the United States, there are two types of employee stock options — non-qualified stock options (NQSOs) and incentive stock options (ISOs). While similar in concept, the taxation of the two is very different.

 NQSOs are the more commonly used of the two. Once an employee has satisfied vesting requirements, he may exercise the options any time before the end of the term. Assuming it’s a cashless exercise, ordinary income is realized and taxed accordingly. At the same time, the company gets a tax deduction.

 ISOs offer a more favorable tax treatment to employees, but the news is not all good. When an employee exercises ISOs, there is no taxable event. At the time the shares are sold, it’s all considered capital gains. But here’s the catch – the employee must hold the shares for one year after exercise in order to get this special tax treatment. In that time, the share price could drop and turn the capital gain into a capital loss. Additionally, the company is not entitled to a tax deduction. In my opinion, these two issues have significantly limited the appeal of ISOs.

 Now let’s assume the Republicans are successful in extending the Bush tax cuts, leaving the highest marginal tax rate for ordinary income in the mid-30% range. They abolish the capital gains tax and reduce the corporate tax rate to 12.5%. And let’s assume that the Alternative Minimum Tax (AMT) is also eliminated, since neither party likes it. If these tax policies were to come to pass, how do we like ISOs now?

 I think they look much more interesting. From an employee perspective, any realized gain is entirely tax-free. This might make the risk of the one-year holding requirement more palatable. From an employer point of view, the tax deduction is still lost. But, is there an argument to be made that fewer ISOs have to be granted in order for the employee to realize the same after-tax gain as NQSOs? If that’s true, then the company has a potential offsetting savings from reduced stock option expense and lower shareholder dilution. And, I think there’s a case that can be made from a corporate governance perspective as well. Shareholders would certainly approve of a stock option plan that only rewards executives if stock price performance is sustained.

 I’m not saying ISOs would be a silver bullet. There are some other limitations and rules associated with them that can be challenging. But if the Republicans prevail, they might be worth a second look. 

Judy L. Freides is the resident blogger for CompDevil, a new company providing Human Resources professionals with on-demand access to compensation experts via live chat. Judy brings over 15 years of experience to bear in her weekly blog, which focuses on the nuances and pitfalls of compensation around the world. Her recent role as Global Compensation Director for a company with over 100,000 employees in 100 countries leaves her skeptical that there’s much out there that she hasn’t come across. But then again, she loves surprises.

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Comments

[Dan Walter]

Hi Judy,
Interesting speculation on ISOs. I remember a time when Long-Term Cap Gains rates were lower and it was more beneficial for people to hold their exercised shares.

Sadly, even in those more beneficial times, more than 85% of all ISO exercises were Same-Day-Sales, which effectively turn ISOs in NQSOs (Ordinary Income at exercises, taxed in year of exercises....but no withholding).

AMT was less of an issue then, mainly because stock options sizes were so much smaller (and AMT has barely been adjusted for inflation since 1969.) Even without the AMT risk people tended to exercise when they needed money.

If companies lose the potential tax deduction associated (currently they can expect 85-90% of all ISOs to result in a corporate tax deduction) with ISOs, i think we will see an almost immediate drop off in their use. Already companies state the lack of guaranteed tax deductions as one of the biggest drivers of reduced ISO usage.

Now, if both AMT and Cap Gains go away, you will certainly have some executives demanding these tax free options. In my experience nearly all ISOs held to a qualifying disposition are held by people who can live comfortably without the gains. This means one more separation between the "haves" and the "don't have as much's (that can't be a real word)."

I am not sure that the long term result of this will be positive.

Lastly, I can see many states who depend on ISO income (New York, California, Washington etc.) changing their tax codes so that ISOs are taxed at exercise, instead of at disposition. A couple states already do this, most notably Pennsylvania.