Here is an outline of some of the principal differences between two different types of compensatory stock options: incentive stock options (ISOs) and nonstatutory stock options (NSOs). This outline is intended as a starting point, but does not address all of the tax aspects of stock options or all of the differences between ISOs and NSOs. This outline is based on U.S. federal tax treatment and does not address any differences under state, local or foreign tax law.
- ISOs may only be granted to employees; NSOs may be granted to employees, consultants and advisors.
- The exercise price of an ISO or NSO must be at least 100% of the fair market value of the underlying shares on the date the option is granted. For ISOs granted to an individual who owns more than 10% of the company, the exercise price must be at least 110% of the fair market value of the shares on the date of grant, and the option term cannot exceed 5 years.
- In general, neither ISOs nor NSOs are taxable at the time of grant.
- Ordinary income tax does not apply at the time of exercise of an ISO, but alternative minimum tax (AMT) may apply, especially for executives. Upon sale of ISO shares, tax is based on the difference between the sale price and the original exercise price. If the holding periods noted below have been satisfied, the entire amount of gain is eligible for long-term capital gain treatment.
- Ordinary income tax applies at the time of exercise of an NSO, based on the difference between the exercise price and the fair market value of the shares at the time of exercise. The taxable compensation upon exercise then effectively increases the tax basis of the shares. Upon sale of NSO shares, tax is based on the difference between the sale price and the fair market value on the date of exercise, and the amount of this difference may be eligible for capital gain treatment (depending on how long the shares are held).
- The first $100,000 in aggregate exercise price for options vesting during any calendar year is eligible for ISO treatment. Options in excess of this amount are treated as NSOs from the date of grant. As an example, for options priced at $0.10 per share, this means that up to 1,000,000 shares can vest in a calendar year and be treated as ISOs. Any additional shares vesting in that calendar year, even if originally designated as ISOs, will be considered NSOs from the date of grant. Note that in the calendar year of an employee’s first anniversary under a typical 4-year vesting schedule, vesting will include the first 25% of the option shares plus monthly vesting between the anniversary date and the end of the year (up to an additional 22.9% of the option shares).
- ISOs that exceed the $100,000 limitation in any calendar year must be tracked with separate ISO and NSO components (and are sometimes issued in separate stock option agreements, one designated as an ISO and the other as an NSO).
- In order to retain ISO treatment, ISO shares must be held for at least 12 months following exercise of the option (and at least 24 months from the date of option grant). If shares are sold before the completion of either of these holding periods, the ISO is “disqualified” and becomes an NSO for most purposes. At that point, the company is generally required to treat the option as an NSO for accounting and withholding purposes.
- Except in cases of termination of employment, employees often wait to exercise (and to pay the purchase price) until there is a market for the shares (such as following an initial public offering (IPO) or in connection with a merger) and then sell shares soon after exercise resulting in disqualification. A large number of ISOs are ultimately disqualified for this reason.
- The company may generally take a tax deduction for the compensation deemed paid upon exercise of an NSO. Some companies prefer to grant NSOs for this reason.
- Employees may prefer ISOs due to the ability to defer ordinary income tax until the sale of the shares and the potential for a lower tax rate on the component of gain between grant and exercise (if holding periods are satisfied). Note that alternative minimum tax, if applicable, is not deferred for the exercise of an ISO.
- The company should consult with its outside accountants regarding the various tax, accounting, withholding and financial statement differences between ISOs, disqualified ISOs, and NSOs.
- Individual option recipients should always consult with their personal tax advisors because of differences in individual tax situations.
- For some of the best guidance on the tax treatment and other key aspects of stock options, I highly recommend The Stock Options Book by Alisa J. Baker published by the National Center for Employee Ownership.