ISO vs NSO: When Do You Pay Taxes on Stocks?

If you're confused about employee stock options (ESOs), you're not alone.

A 2018 study by Schwab Stock Plan Services found that 76% of workers have never exercised their stock options or shares, with 48% admitting this was due to fear of making a mistake.

In this piece, we'll walk you through the way stocks are taxed, the $100k rule, and the differences between incentive and non-qualified stock options.

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Do You Pay Taxes on Stocks?

In the U.S., the taxes levied on investments are called "capital gains." These taxes apply when an investment, such as stocks or real estate, is sold.

For example, let's imagine you purchase stock options valued at $1,000. You hold these shares for five years, during which time their value increases to $1,500, then you decide to sell. The $500 profit you earned by selling your stocks are your capital gains in this scenario.

It's important to note that capital gains only apply when you sell an asset. As long as you hold the asset, you can accumulate "unrealized capital gains" that will not be taxed.

ISO vs. NSO: What's the Difference?

Each year, the U.S. Internal Revenue Code puts a limit of $100,000 in incentive stock options (ISOs) per every employee.

Options that don’t fall within this limit are classified as non-qualified stock options (NSOs), which are subject to tax once exercised and may be taxed at a higher rate.

Who’s Responsible for Applying the $100K Rule?

Companies and their respective legal teams are in charge of applying the specific ISO $100K rule as outlined in the Internal Revenue Code (IRC) to ensure all ISOs and NSOs are divided properly. For this reason, it’s crucial that companies and their legal teams track how the rule is applied to option grants.

In some cases, complicated modifications and transactions may be required to interpret and apply the $100K rule. Careful review and management is needed, and there are various approaches companies and law firms can take to keep track of grants and adhere to the rule.

ISO/NSO splits can often be a bit tricky for both companies and employees. Not only can they impact the amount of taxes a company needs to withhold, but they can also affect how much employees owe on their taxes since ISO and NSO tax treatment may vary.