There are two types of stock options that companies can offer to their employees: non-qualified stock options (NQSOs) and incentive stock options (ISOs). Both have their pros and cons, so it’s important to understand the difference between them before making a decision with your LMT stock. As many of you know, it’s likely that you’ll receive some form of equity-based compensation during your time with Lockheed & Martin and it gets insurmountably complicated. Many people are hiring equity compensation-focused financial advisors to help them. 

Disclosure: If you’re not sure how to think about your potentially life-changing equity compensation, you should hire a financial advisor in colorado (preferably an equity compensation-focused financial advisor/wealth management firm in Colorado like Progress Wealth Management).

What are non-qualified stock options (NQSOs)?

Non-qualified stock options are a type of employee stock option that does not provide certain tax benefits that qualified stock options do.

When non-qualified options are exercised, Lockheed & Martin employees will recognize ordinary income based on the difference between the exercise price and the fair market value of the stock on the date of exercise. The employer will also generally be subject to employment taxes on the income recognized by the employee.

What are Incentive Stock Options (ISOs)?

Incentive stock options (ISOs) are a type of employee stock option that provides favorable tax treatment to the recipient. Incentive stock options (ISOs) are typically granted to key employees that are fundamental to the operation and success of the firm as an incentive for them to remain with the company. 

Non-qualified stock options do not receive favorable tax treatment and are typically granted to all employees. When the employee exercises the option, they will pay taxes on the difference between the strike price and the fair market value of the shares at the time of exercise.

Both ISOs and non-qualified stock options can be used as a tool to retain key employees and provide them with an incentive to stay with the company. However, iso stock options offer a more tax-advantageous way to do so. Interested in learning more about ISOs? Click here to get more information. 

The 3 Differences Between ISOs and NQSOs

The main difference between the two is that NQSOs are subject to income tax when you exercise your NQSO and buy at the set purchase price, while ISOs are not subject to income tax but may be subject to a different type of tax called “Alternative Minimum Tax” (AMT). 

The alternative minimum tax is only owed if the combination of the “bargain element” + your household income puts you above the Alternative Minimum Tax Threshold for the year. If it does, you could owe a huge amount of cash to the IRS, so be aware of this when you exercise your ISOs.

The next time you may owe taxes when you sell your ISOs or NQSOs is when you sell the stock you get by exercising the contract. For ISOs and NQSOs, you’ll pay capital gains taxes on the difference between your “Cost basis” and the sale price but the question is, how do you find your “Cost basis”?  

For ISOs, your cost basis is always your set purchase price (aka your strike price). For example, if you own an ISO that gives you the right to buy 1000 shares of your company stock at 10 cents per share which you exercise and buy the stock at 10 cents which you subsequently sell for $100/share… your capital gain will be $100 – .1 = $99.90. per share. That can be huge, so again, be careful. Read our article here if you’d like more information on the top 5 things you must know before selling your ISOs. 

For NQSOs, your cost basis is always the current market value when you exercise your contract. For example, if your contract gives you the ability to buy the stock at a set price of 10 cents per share and the market value when you exercise is $10/share… you’ll pay ordinary income tax on the difference between $10 and 10 cents which is $9.90 capital gain. Following this, you’ll have to sell the stock. If you sell for $100/share, you’ll pay taxes again on the difference between $100 and $10 cost basis which is $90/share as a capital gain. 

This can make a big difference in the amount of tax you owe. For example, if you exercise an NQSO when your income is high, you may be in a higher tax bracket and owe more in taxes. On the other hand, if you sell an iso after it has increased in value, you will only owe taxes on the capital gain.

Another difference between NQSOs and ISOs is that NQSOs can be subject to payroll taxes, while ISOs are not. Payroll taxes are deducted from your paycheck and go towards Social Security and Medicare. If you have an NQSO, your employer will withhold payroll taxes from your paycheck when you exercise the option. With an iso, you will not owe any payroll taxes.

Long story short, how you strategize your exercise of these options gets incredibly complicated. If you make a mistake, you could pay much more taxes than you’d like. If you’re not sure how to think about your plan to exercise and sell the stock, contact a financial advisor/wealth management expert in Colorado (preferably an equity compensation-focused financial advisor). Read more here.

Pros and cons of NQSOs and ISOs

There are two main types of stock options that companies offer to employees: non-qualified stock options (NQSOs) and incentive stock options (ISOs). Both have their own set of pros and cons that you should consider before deciding which type is right for you.

Non-qualified stock options are the more common of the two and are less restricted than ISOs. With NQSOs, you don’t have to worry about meeting certain holding periods or income requirements – you can exercise your options as soon as they vest. However, NQSOs are subject to taxation, both when you exercise your options and when you sell the underlying shares.

Incentive stock options are more advantageous from a tax perspective. If you hold your ISO shares for at least one year after exercising your options and two years from the grant date, you will be eligible for long-term capital gains treatment when you sell. This can result in significant tax savings compared to NQSOs. However, ISOs are subject to stricter rules and restrictions, such as income requirements and mandatory holding periods.

So which type of stock option is right for you? It depends on your individual circumstances and financial goals. Be sure to talk with a financial advisor in Colorado before making any big decisions (preferably an equity compensation-focused financial advisor like Progress Wealth Management). 

So, you understand the tax differences. Other Than taxes, Why Else Should Lockheed & Martin Employees Care?

Lockheed & Martin has increasingly supported paying their employees using equity every year the last 4 years and they’re only increasing their support for it. At this rate, you may receive over 20% of your annual compensation in equity in 10 years. Without a good strategy for how to use it, you may end up with a ridiculous tax bill. 

Here’s some data to show you the trends. Source.

Lockheed Martin stock-based compensation for the quarter ending June 30, 2022 was $0.134B, a 5.51% increase year-over-year.
Lockheed Martin stock-based compensation for the twelve months ending June 30, 2022 was $604M, a 4.68% increase year-over-year.
Lockheed Martin annual stock-based compensation for 2021 was $0.227B, a 2.71% increase from 2020.
Lockheed Martin annual stock-based compensation for 2020 was $0.221B, a 16.93% increase from 2019.
Lockheed Martin annual stock-based compensation for 2019 was $0.189B, a 9.25% increase from 2018.

Which is right for you?

If you’re considering whether to start exercising your non-qualified stock options (NQSOs) or your incentive stock options (ISOs), it’s important to understand the key differences between the two.

NQSOs are subject to income tax, while ISOs are not. That means that when you exercise your NQSOs, you’ll owe income tax on the difference between the strike price and the fair market value of the stock at the time of exercise. With ISOs, you don’t owe any tax until you sell the shares, at which point you’ll pay capital gains tax on the difference between the sale price and your strike price.

So, which is right for you? If you’re looking for immediate tax savings, then NQSOs may be the way to go. However, if you think there’s a chance the stock will increase in value significantly and you can hold onto it for a long period of time, then an ISO may be a better choice.

Of course, you’ll need to weigh the pros and cons of each option and make the decision that makes the most sense for your personal financial situation.

Conclusion: Here’s What You Should Understand About NQSOs and ISOs

NQSOs and ISOs have different rules and regulations. While ISOs require you to meet certain criteria in order to be given, NQSOs are not subject to such restrictions. This is why they can be given to a wider range of individuals than ISOs. Additionally, while when you exercise an ISO, you do not owe taxes on the sale of the stock, when you exercise an NQSO, you will owe the difference between the strike price and the market price at the time of sale (lesser taxes are owed due to it not being subject to all of the same restrictions as ISOs). Finally, as opposed to ISOs with generally longer vesting periods, NQSOs generally have shorter vesting periods (due to this difference in how it is treated thereby being more flexible for companies in retaining talent).