You run a start-up and want to grant stock options. You keep hearing that there are two types, and you want to understand the differences between the two. You’ve come to the right place.
The two types of stock options are incentive stock options, commonly referred to as ISOs (pronounced “eye-sews”) and nonstatutory stock options, commonly referred to as NSOs (pronounced “en-es-ohs”).[1]
All differences between ISOs and NSOs are tax-related. ISOs are generally viewed as more tax-favorable to the recipient and thus come with more requirements. An NSO is any option that doesn’t qualify as an ISO.
Either type of stock option is a right to purchase a certain number of shares of stock, at a set price, over a limited period of time.
In stock option lingo, “exercising” means paying to purchase the underlying shares. While some options allow “early exercise” whereby an option holder is allowed to purchase shares before they vest, for purposes of the below tax discussion I am assuming a regular exercise where only vested shares are being purchased.
I am also assuming that each option has been granted with an exercise price equal to or greater than the fair market value of the underlying stock on the date of grant. This is a requirement for ISOs, and is generally also necessary for NSOs so that one doesn’t run afoul of tax code Section 409A. For this reason, it is recommended that a company obtain a tax code Section 409A valuation prior to granting options. These cost around $4,500.
While the below describes the differences between ISOs and NSOs in more detail, the big difference is that ISOs don’t cause ordinary income tax on exercise, even if there is a spread. That benefit may be overstated however because (i) the company loses the deduction with respect to the exercise, (ii) there can still be alternative minimum tax (AMT) caused by the exercise, and last but not least, (iii) most optionees never exercise, rather hold the option until a cash-out, in which case NSOs and ISOs are treated exactly the same (just like a bonus).
Nonstatutory Stock Options
Tax treatment
- On grant: No tax.
- At exercise: The spread, meaning the difference between fair market value on the exercise date of the shares being purchased and the exercise price, is ordinary income, subject to withholding if the option holder is an employee, and in any event subject to ordinary income tax rates and employment tax.
- At sale of shares: Any appreciation between the date of exercise and the date of sale will be capital gain, long-term if the shares were held for more than one year.
- At cash-out: If the NSO is never exercised but is instead cashed out, the entire amount received will be ordinary income, subject to withholding (if applicable) and employment tax.
The tax at exercise is generally viewed as the big tax downside of NSOs. From a company’s perspective however, it creates a deduction equal to the ordinary income recognized, so it has a tax benefit that ISOs do not have.
Incentive Stock Options
Tax treatment
- On grant: No tax.
- At exercise: No ordinary income tax; spread is an AMT preference item unless shares are disposed of in year of exercise.
The tax treatment on the sale of shares depends on whether the disposition was a “qualifying disposition” or not. A qualifying disposition is when the shares are not sold until it has been more than two years from the option grant date and more than one year since the exercise date.
- Qualifying disposition: Long-term capital gain on difference between sale price and exercise price; AMT gain is excess of the sale price over the fair market value on the date of exercise.
- Disqualifying disposition: Spread is ordinary income, subject to income tax but not employment tax; capital gain on difference between sales price and fair market value on exercise date; if fair market value has gone down since exercise date, ordinary income capped at difference between sales price and exercise price.
- At cash-out: If option is never exercised but is instead cashed out, the entire amount received will be ordinary income, subject to withholding and employment tax.
The fact that there is no regular income tax on exercise of an ISO is generally viewed as the big tax advantage of ISOs. However, don’t forget that alternative minimum tax may apply. In addition, the company generally does not get a deduction with respect to ISOs, and to receive the favorable “qualifying disposition” tax treatment the optionee must exercise and the shares must be held until more than two years from the date of grant and more than one year from the date of exercise.
ISO Requirements
For an option to qualify as an incentive stock option, generally, the following requirements must be met:
- The recipient must be an employee of the corporation granting the option, or a subsidiary of the corporation granting the option.
- The option paperwork must not state that the option is not an ISO.
- The company’s stockholders must approve the equity plan within 12 months before or after the equity plan is adopted by the corporation.
- The option must be granted within 10 years from the earlier of the date the plan was adopted or the plan was approved by the shareholders. This is usually accomplished by setting the term of the plan to be 10 years from the earlier of those two events.
- The equity plan should designate the employees or class of employees eligible to receive ISOs and the maximum number of shares granted under the plan as ISOs.
- The term of the option must be 10 years or less (5 years or less if the recipient is a greater than 10% stockholder);
- The exercise price must be at least 100% of the fair market value of the underlying stock on the date of grant (at least 110% if the recipient is a greater than 10% stockholder).
- The terms of the option must prohibit the transfer of the option by the employee, other than by will or the laws of descent and distribution and provide that the option is exercisable only by the employee during the employee’s lifetime.
- Only $100,000 worth of shares underlying incentive stock options may first become exercisable in any given calendar year for a single option holder. Any excess will automatically become NSO shares.
- If unexercised, an ISO turns into an NSO the day three months and one day after employment terminates for reasons other than death or permanent and total disability, and one year and a day after employment terminates due to permanent and total disability.
Mike Baker frequently advises with respect to stock options. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] These are also sometimes referred to as nonqualified stock options or NQSOs (pronounced “en-que-es-ohs”).