TCP CPA Practice Questions: Stock Options (ISOs and NSOs)

Welcome to another TCP walkthrough video. I'm Logan and in today's video we're going to be going over stock options, mainly ISOs and NSOs. And we're going to be doing that the Superfast CPA way, which is typing straight into questions to learn the material. If you don't know much about our strategies, make sure you go to superfast CPA.com and check out our free one hour webinar training where we teach the key ingredients to passing the CPA exam. Again, it's one hour, it's free and it will save you so much time struggling with your process

Before we start, one thing I want to say about this video, we will only be going over five questions in this video

whereas members of Superfast CPA will have access to the full video where we go over 10 questions

So if you like this, then there's more of it if you're a Super Fast CPA member

With all that said, let's dive straight into the questions. Okay, here's question one

On May 13th, Omega Enterprises grants an employee, Carlos, 120 ISOs, with the strike price of $35 per share, when the market price is also $35 per share

Carlos exercises all his options on November 29th of the same year, when the market price has increased

to $250 per share. Calculate the income Carlos should recognize from exercising his ISOs for his tax return for that year

So just a reminder, ISO stands for incentive stock option. And since this is the first question of the video, we don't really know how this works

So let's go ahead and go straight into the answer to learn what exercising an ISO does

Okay, and the answer is $0. For ISOs, there is no taxable income recognized at the time of exercise for regular income tax purposes

This characteristic of ISOs under the tax code is intended to provide tax benefits to employees aligning their interests with the growth of the company

While the increase in market price does imply a gain on paper, this gain is not taxable upon exercise, but only upon eventual sale of the shares if specific holding period conditions are meant

ISOs are a type of equity compensation award, just like RSUs if you've watched that video

Equity compensation refers to the practice of granting company shares or options to purchase shares as part of an employee's compensation

Okay, so incentive stock options. When you exercise them, that is not taxable income in that year

We will talk about what happens when you sell them in a second here, but for ISOs, again, not taxed as ordinary income like RSUs were

All right, let's go ahead and go to the next question. Okay, here is question two

Rebecca was granted 100 ISOs by her employer, Vertex Innovations, on April 10th

with a strike price of $10 per share when the market price was also $10 per share

She exercises these options on April 11th the following year when the market price has risen to per share Rebecca decides to sell all her shares on June 15th of the same year the options were exercised when the market price is per share What tax treatment will Rebecca sale receive due to the holding period rules Okay again what are the holding period rules for ISO You probably don know Let go ahead and go into the answer to understand what happens when you sell your ISO So the gain will be taxed as ordinary income because she did not meet the required holding period

Okay, so let's learn about this. For ISOs to receive favorable tax treatment where gains are taxed at the long-term capital gains rate

Rebecca must hold the shares for at least one year after the exercise date and two years after the grant date

In this scenario, Rebecca sells the shares just a few months after exercising and less than two years from the grant date

Therefore, the gain from the sale of the shares, $20 per share, from the exercise price to the sale price

will be taxed as ordinary income because she did not meet the required holding periods

So specifically for ISOs, when you sell them for that capital gain to be taxed as a long-term capital gain

you have to have held those ISOs at least one year from the date

You exercised them and two years from the date that option was granted to you

If you don't meet both those requirements, that ISO capital gain will be taxed as ordinary income

And that's pretty much what you need to know for ISOs. On the exercise date, they're not taxed

And then when you sell them, unless you meet these requirements, the capital gain is taxed as ordinary income

Now let's go ahead and look at NSOs. Okay, here is question three. Jordan is granted 200 NSOs by his employer Fusion Enterprises on May 15th with a strike price of $10 per share when the market price is also $10 per share

Jordan exercises these options on May 15th of the next year when the market price has increased to $25 per share

Calculate the amount of income Jordan will recognize as taxable on the day he exercises his NSOs

assuming he exercises all his options. Okay, NSO, that's a non-qualified stock option

just in case you don't know what that is, and is a non-qualified stock option the same as an incentive stock option

when they're exercised? Is it going to be taxed as ordinary income or not

Let's go ahead and look at the answer to find out how it works. And the answer is it would be $3,000

So it looks like it is different from an ISO. When NSOs are exercised

the difference between the exercise price and the market price at the time of exercise is recognized as ordinary income

For Jordan, the difference per share is $15, so that's the market price, less the exercise price

And since he exercises 200 shares, that results in $3,000 of additional taxable income

This income is reported as part of his W-2 wages and is taxed at ordinary income rates

Okay, so kind of similar to RSUs, again if you watched that video However the ordinary income that taxed is not just the fair market value at that date like an RSU For this it the difference between the strike price and the market

price on the date of exercise. All right, let's go ahead and go to the next question. Okay, here's

question four. Jessica is granted 250 NSOs by her company Bright Tech on June 1st with a strike price

of $20 per share when the market price is also $20. She exercises these options on June 1st of the

following year when the market price has increased to $35 per share. Jessica sales all the shares on

December 5th of the same year when the market price is $45 per share. So we need to calculate the total

gain that she'll recognize on the sale of her shares and determine how this gain is taxed

Assume she exercises all her options. Okay, so basically it's asking us what is the total income that's

going to be taxed here. Okay, you learned a little bit about this in the previous question. The only

question is how is the gain going to work? Go ahead and pause the video, see if you can figure this out

and when you're ready, come back, and we will look at the answer together. All right, and the answer is that there would be $3,750 of ordinary income and a $2,500 capital gain

So let's look at the whole calculation. The calculation of Jessica's financial outcome from exercising and selling her NSOs involves two components

So first, the income and exercise. And that would be the difference between the strike price and the market price at the time of exercise as taxed as ordinary income

And again, that's the market price, less the strike price, $15 per share, times 250 shares

That's $3,750. The gain realized from the increase in value after exercising the options until the sale of the stock is taxed as a capital gain

This is calculated as the sale price per share, less the exercise price per share

And that gives you $10 per share, and that will be a total gain of $2,500

So she has ordinary income and $2,500 of capital gain at the time of sale

All right, let's go ahead and go to the next question. Okay, here is question five

Elena is evaluating the differences between being granted incentive stock options or ISOs

and non-qualified stock options or NSOs by her employer tech global. Which of the following statements accurately describes a fundamental difference between

ISOs and NSOs? Okay, we haven't really learned about this yet. Are ISOs only granted to management or are NSOs taxed at the time of grant while ISOs are taxed

at the time of exercise? We know that one's wrong. So take a second, read through this, see if you can figure out which the correct answer is based off of what we learned so far

And if not, let's go ahead and look at the answer. Okay, and the answer is that NSOs require the holder to pay tax on the bargain element as ordinary income at the time of exercise, whereas ISOs do not lead to immediate regular income tax consequences when exercised

So you probably knew that after looking at the different options And this is a big difference between ISOs and NSOs For ISOs when they exercised they do not create a taxable event for regular income tax purposes

However, the spread between the exercise price and the market price at the time of exercise

may be subject to alternate minimum tax, and we'll learn about that in another video

The favorable capital gains treatment is only realized if the shares are sold at least one year after exercise

and two years after the date the options were granted. And now NSOs, when they are exercised, the difference between the exercise price and the market value of the stock at that time is taxed as ordinary income in the year of exercise

Kind of similar to RSUs, but RSU is just the fair market value at that date

This income is subject to regular income taxes and must be reported as part of the individual's W-2 wages

All right, we've learned a lot about ISOs and NSOs in just five questions

Before we go any further, let's go ahead and do another part of the Superfast CPA strategy

called pillar topics. Now if you don't know much about our strategies, again, pillar topics

is the idea that as you're going through questions to learn the material, you will see

things that keep popping up in the questions. These are the concepts that are obviously important

and that you're supposed to be learning from your review course. You've seen them in like three

or four questions throughout your study session. So let's go ahead and look at the pillar

topics for this video. Okay, here are the pillar topics. Okay, there are typically two kinds of

stock options, ISOs and NSOs, at least for the CPA exam. ISOs are typically

typically only for employees and are not taxed at the time of exercise. However, the spread or the difference between the market price and the strike price at exercise

can be subject to AMT. And again, AMT something will cover in a different video

If ISOs are sold, the gain is treated as ordinary income for tax unless it is held for more

than one year after the exercise date and for more than two years after the date the options were granted

Now, NSOs are less restrictive, but they are taxed upon exercise. On the date of exercise, the difference between the strike price and the market price is included in ordinary income, usually on the employees, W2

Upon sale, any capital gain is taxed as either short term or long term based off of the exercise date

All right, those were the pillar topics for this video. And that is the end of the five questions for this video

Again, a reminder that member of Superfast CPA will have access to the full 10 question video to get more practice

So if you liked this, make sure you go check out our Superfast CPA training

training webinar we have on superfast cpa.com, where we go over the key ingredients to passing

the CPA exam. Again, it's only one hour, it's free, it is something you do not want to miss

If you liked going through questions as your main learning material, make sure you check out our Superfast CPA app. We have five question mini quizzes that you can easily access on your

phone all throughout your day. If you liked this video, make sure to like it and leave a comment

I hope this was helpful, and I will see you in the next video