What are Incentive Stock Options (ISOs)?
Incentive stock options are a type of stock option that can only be granted to employees. ISOs qualify for preferential tax treatment under the United States Internal Revenue Code if they meet certain criteria. We cover these requirements in depth below.
The tax benefit ISOs confer is that employees who receive ISOs do not pay taxes when they exercise the options, only when they sell the stock. Incentive stock options are sometimes also referred to as qualified incentive stock options or statutory stock options.
What are Non-Qualified Stock Options (NSOs)?
Non-qualified stock options are a type of stock option that do not have the restrictions that ISOs have. NSOs can be granted to employees, contractors, directors, vendors, and other parties. There is also no limit on the value of NSOs that can be granted in a year. Non-qualified stock options are not subject to the same favorable tax treatment as ISOs. They are taxed at the ordinary income tax rate upon exercise on the difference between the exercise price and the fair market value (FMV) of the underlying shares.
What’s the difference between ISOs and NSOs?
The main difference between ISOs and NSOs is that ISOs come with no tax liability on exercise, but come with a set of requirements, whereas NSOs come with tax liability on exercise, but do not have the same requirements.
What are the requirements for ISOs?
The main requirements of ISOs are:
- A company can only grant ISOs to employees.
- ISOs must be priced at FMV, which is determined by a 409A valuation.
- In any given calendar year, the FMV of the total amount of ISOs that are exercisable is limited to $100,000, any excess will be treated as an NSO
- Employees must exercise ISOs within three months of leaving the company.
- ISOs can only be transferred to someone else upon the death of the recipient.
- Employees must exercise their options within 10 years of the grant date.
- ISOs must be held for more than two years from the time of grant and the shares obtained upon exercise of an ISO must be held for more than one year after exercise. Selling the ISO before this period is known as a disqualifying disposition which leads to losing the tax benefits of the ISO. Selling after the period is known as qualifying disposition.
If ISOs meet these criteria, the difference between the FMV and the strike price, also known as the spread, is not subject to ordinary income tax or employment tax, but is subject to the alternative minimum tax (AMT). The AMT is designed to make sure that certain taxpayers, generally with high income, pay at least a minimum tax, limiting their possible tax deductions and exclusions.
If a company tries to grant ISOs, but those ISOs do not meet all the qualifying criteria, the option grant will still be valid, but the options will be treated as NSOs.
How ISOs and NSOs work
ISOs are typically granted on a vesting schedule, starting from the grant date, the date the options were issued. Employees can only exercise options once they have vested. When an employee exercises ISOs, they must include the spread to calculate their AMT liability if they hold the shares they acquired through the ISOs at the end of the calendar year. If an employee holds their shares for a period of at least one year after the date of exercise, and at least two years after the grant date, they owe long-term capital gains taxes instead of ordinary income taxes.
Exercising NSOs is less complicated. When an employee exercises NSOs, they must pay ordinary income taxes on any gains, represented by the difference between the strike price and the fair market value at the time of exercise. After that, they pay capital gains tax rates on any gain from the stock between when they purchased the stock and the sale price. Depending on the holding period after exercise, the employee will owe short-term capital gains tax rates (if the holding period is less than a year) or long-term capital gains tax rates (if the holding period is more than one year).
Which is best for startups?
ISOs and NSOs serve different purposes. ISOs are a popular form of employee stock options for startups because of the tax implications for employees. They are often part of an employee option pool, set aside from the company’s stock with the goal of retaining key hires at early-stage startups.
There are good reasons to use both. ISOs offer a more favorable taxation for employees but come with more restrictions. NSOs can be useful as equity compensation to reward non-employees such as contractors and service providers.
