Today, many companies issue stock options to their employees because this ties employee compensation to the success of the company. There are two basic types of options: Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs). While both types of options benefit the employee as the company valuation rises, there are significant differences in taxation.

The main advantage of an ISO is favorable tax treatment; however, there are holding period requirements which must be met. An employee must sell the stock at least two years from the date of grant and one year from the date of exercise in order to have long-term capital treatment on the appreciation. Furthermore, there are Alternative Minimum Tax adjustments at date of exercise and date of sale.

For example, let’s say 1,000 ISOs are granted with an exercise price of $10. As long as this is higher than the fair market value of the stock, there will be no taxable income at the date of grant. The employee waits one year to exercise the ISOs while the stock is at $20 resulting in an AMT adjustment of $10,000. One year from the date of exercise, the employee can sell those shares at $30 a share and will receive $20,000 taxed at long-term capital gain tax rates and a negative AMT adjustment of $10,000.

If the holding period requirements are not met, the sale is known as a disqualifying disposition and any appreciation is taxed at ordinary income tax rates and the AMT adjustment is reversed.

This is essentially how a Nonqualified Stock Option functions. There is no holding period requirement thus all appreciation is taxed at ordinary income tax rates and there are no AMT adjustments.

While the preferential tax treatment of ISOs is attractive, there are many factors to consider such as cash required up front to purchase the options, the AMT adjustment potentially resulting in higher taxes in one year and uncertainty of the stock price after the holding period requirement.

Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Capital Management, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.

We had a quiet third quarter, making only a few small changes within our technology sector. We added a position in Microsoft Corp (tkr: MSFT). Microsoft is the second-largest holding in the S&P 500, making up about 3.4% of the index. Under leadership from CEO Satya Nadella, Microsoft has developed several profitable, fast-growing revenue streams, particularly in the cloud. “Commercial Cloud” revenue, which includes Office 365, Dynamics 365 and Azure, has been growing about 50% each year, and currently is roughly $7 billion. We believe that Microsoft has emerged as a clear winner alongside Amazon in the cloud. As the transition to the cloud continues, Microsoft should continue to benefit from its leadership position. Microsoft cloud revenue is growing much faster than its competitors, as it continues to gain market share.

Furthermore, we like the $7.5 billion acquisition of GitHub that was announced in June of this year. GitHub is a community of 28 million software developers who contribute code to more than 85 million open-source software projects. We think this was a smart acquisition by Microsoft, as it should help fuel Azure growth going forward. Alongside the increasing revenue growth over the past several years, Microsoft’s valuation has risen. We decided to buy a 2% position, smaller than the market weight, given the rise in valuation. If we see this valuation decline or if we recognize further growth potential at the company, we could look to add more.

We added to our position in Qualcomm (tkr: QCOM) ahead of several possible positive catalysts for the company. Qualcomm has been entangled in a mess of regulatory fights, a bitter legal battle with Apple, a failed hostile takeover attempt by Broadcom, and roadblocks in its own acquisition of NXP Semiconductors. However, in the last few months, we have seen resolutions to many of these issues. Most of the regulatory bodies across the globe challenging Qualcomm’s business practices have concluded their investigations and Qualcomm has paid the corresponding fines. The takeover attempt by Broadcom was ultimately blocked by the Trump administration in March. Qualcomm officially abandoned the purchase of NXP Semiconductors in July after Chinese regulators held up approval of the deal as part of the larger trade conflict with the U.S.

Following the termination of the acquisition, Qualcomm announced a $30 billion stock buyback program and mapped out a plan to diversify its revenue beyond the smartphone market. The legal battle with Apple remains an overhang, but there are several upcoming legal events that should steer the two companies toward some kind of resolution. Even if the outcome of a settlement or trial is not 100% a win for Qualcomm/loss for Apple, we think that a conclusion to this fight will overall be a positive for the stock.

Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Roberts Investment Advisors, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.