What’s the difference – ISO v. NSO
February 4, 2022
Founders are always on the hunt for different ways to both entice top talent to come work for them and to incentivize that talent to stay with the company. One avenue used to attract and retain talent is the granting of stock options. Under this larger umbrella of stock options are two types that startups often grant: incentive stock option (ISOs or statutory stock options) and non-qualified stock options (NSOs or non-statutory stock options).
Let’s start with the similarities. ISOs and NSOs grant the holder the right to purchase shares of the company’s stock at a defined exercise price. The catch with such options (if you can call it a catch) is that the exercise price/options are only valuable to the holder if the underlying stock appreciates in value. For example, if the exercise price of the options is $0.50, but the stock price is $0.40 then the options are not attractive; the hope for the holder is that by the time they are exercised, the stock price is much higher than the exercise price so that the stock may be purchased at a “discount” (ie exercise price of $0.50 and the stock is worth $1.00).
Another similarity is that the option exercise price must reflect no less than fair market value on the date of grant to avoid certain onerous tax implications. Further, if the option becomes exercisable (vested) over a period of time, the option will not be taxable at the time an option becomes exercisable, even if the fair market value of the underlying stock is higher than the exercise price at the time the option becomes exerciseable.
A stock option plan may permit the granting of both ISOs and NSOs—so employees can be granted both types of options under one plan. There are differences, however, when it comes to taxes.
- The exercise price of an ISO must be 110% of the stock’s fair market value if the ISO is granted to a shareholder who owns more than 10% of the issued and outstanding shares.
- An ISO exercise does not trigger immediate income upon exercise for income tax purposes. The spread at exercise may be includible for alternative minimum tax purposes, however.
- Exercise of an ISO does not trigger employment tax withholding.
- If the stock is held for at least 2 years after the option is granted AND at least one year after the option is exercised (a qualifying disposition), the income from the sale of such stock is characterized (for tax purposes) as long-term capital gain. There may also be additional AMT implications.
- If the holding periods are not satisfied (a disqualifying disposition), then the income is taxed as an NSO would be: the spread at exercise is taxed as income (in the year of the sale) and the rest is either short-term or long-term capital gain.
- The option plan must be written and specify the maximum number of shares issuable through ISOs.
- The plan under which the ISOs are granted must approved by the shareholders within 12 months (prior to or subsequently) of the plan’s adoption by the Board.
- Option holder incurs taxable income upon exercise based on spread.
- Federal and state withholding is triggered upon exercise. NSOs avoid the AMT implications associated with ISOs.
- Any gain from the sale of such stock is characterized (for tax purposes) as short-term or long-term capital gain based on how long the stock is held.
- Do not have to be issued under a written plan that specifies the maximum number of shares issuable through NSOs.
- Shareholder approval not required.
- Only “employees” can receive ISOs, not independent contractors or entities. This means non-employee directors cannot receive ISOs.
- The company may not deduct the spread as a compensation expense when exercised.
- The annual limitation on ISOs is $100,000 of stock underlying such ISOs is exercisable in any calendar year.
- The maximum term of an ISO is 10 tears from the grant date (or 5 years from grant shareholders who own more than 10% of the company).
- If an employee is terminated, his or her ISOs must be exercised within 3 months of such termination.
- Employees and independent contractors can receive NSOs.
- The company can deduct the spread as a compensation expense when exercised.
- There is no annual limitation on an NSO.
- There is no maximum term of an NSO.
- If an employee is terminated, his or her NSOs can be exercised at any time prior to the expiration of their term.
Overall, the fact that an employee can exercise an ISO without an tax event provides a significant benefit to ISOs although this benefit only comes into play if the employee holds the stock for the requisite period for a qualifying disposition before some liquidity event. On the other hand, NSOs often have less restrictions and come in handy when founders want to grant stock to non-employee directors.