Stock Option: The Differences Between an ISO and an NSO
Founders are often surprised to see how complex it is to enable their employees to obtain stock options.
The first step is understanding the difference between the two widely different types of stock options: The Incentive Stock Option (ISO) and the Nonqualified Stock Option (NSO).
- An ISO Leads to a Lesser Tax Liability
The main difference between an ISO and an NSO is its tax treatment.
The stock from an NSO is taxed twice: first upon exercise and later when the stock is sold.
With an NSO the difference between the exercise price and the fair market value of the stock is considered ordinary income.
The tax treatment of an ISO often results in less taxes because there are no taxes owed on the spread at the time of exercise.
The stock is mostly subject to long term capital gain tax when it is eventually sold.
- With ISO, Taxes are Due Later
With an ISO, no tax is due until the stock option recipient sells the stock.
In contrast, taxes are owed earlier with NSO: taxation arises as soon as the stock option is exercised (when the stock option recipient actually pays for the stock).
So NSO leads to taxation on the stock even though the recipient is generally unable to sell the non-liquid stock just yet.
- NSO is Most Advantageous for the Company
From the company’s standpoint, NSO is most advantageous because the company can take tax deductions when the employee or consultant exercises the stock option.
That’s because with an NSO the stock option is considered ordinary income to the employee or consultant.
With an ISO, there is no tax deduction for the company.
- ISO is for Employees Only
Another important difference between ISO and NSO is that ISO is exclusively reserved to employees of the company whereas NSO can be granted to any service providers, including employees, directors, contractors and consultants.
- ISO is not Subject to the Valuation Requirements of Section 409A
NSO requires strict adherence with Section 409A. While 409A valuation is beyond the scope of this post, it is important to know that such valuations tend to be expensive and often require a reliable independent appraisal or a valuation from an expert (who may be an insider).
ISO’s valuation requirements are less stringent. An ISO needs only be determined in good faith by the board of directors.
This is a much more reasonable (and less onerous) standard.
Incentive Stock Options (ISO) is Subject to Many Restrictions
ISO is highly regulated. Incentive Stock Options must conform to the various requirements of Section 422 of the Internal Revenue Code, the most important of which are as follows:
1) ISO must be non-transferable, with the only exception being the death of the stock option recipient.
2) Only up to $100,000 worth of stock can be exercised every year. Any shares exercised over the cap receives NSO treatment. This requirement requires much planning on the part of the company and the employee to avoid an ISO disqualification.
3) If a stock option recipient owns more than 10 percent of the company, the exercise price must be at a premium over the fair market value (at least 110 percent).
4) ISO is for employees only.
Relative Simplicity of NSO
An NSO is any stock option that does not meet the ISO requirements. This is why they are called Non-Qualified Stock Options – because they don’t qualify for ISO treatment.
One of the most important NSO requirement is setting the exercise price (or strike price) at fair market value at the date of the grant. As mentioned earlier, a 409A valuations is needed with an NSO, which remains a cumbersome and often expensive process.
Even if You Start off with an ISO, You May End Up with an NSO
The rigid nature of the ISO requirements is such that most ISO do not ultimately achieve ISO treatment. In various situations, an ISO is deemed to become an NSO by operation of law.
For instance, if you do not hold the ISO for the minimum holding period, the stock is treated as though it were an NSO.
The holding period in question is composed of two parts: The stock must be (1) held for two years from the date the ISO was first granted and (2) one year from the date the stock option was exercised.
This holding period is often the reason why the ISO treatment is lost. Indeed, many stock options recipients wait until an acquisition or change of control occurs to exercise their options. At that point, it’s usually too late to hold the stock for an additional year
Non-Qualified Stock Options: Basic Features and Taxation
Two main types of stock options are offered to employees of startup companies:
- Non-qualified stock options
- Incentive stock options.
This covers the basic features and tax treatment of non-qualified stock options.
Non-qualified stock options are often called “non-quals,” NSOs, or NQSOs.
The term “non-qualified” is tax law jargon that means that this type of option does not qualify to receive special income tax treatment. In contrast, incentive stock options, or ISOs, are qualified to receive favorable income tax treatment.
Your non-qualified stock option is a legal agreement between you and the company. It spells out the terms under which the company is willing to sell its stock to you. For example, your stock option allows you to buy a specific number of shares of your company’s stock at a specific price for a specific period of time. The price you can buy stock is known as the exercise price or strike price. The exercise price is usually equal to the value of the company’s stock on the day you received your stock option.
If the price of the company’s stock is above the exercise price, the value of your stock option is equal to the stock price minus the exercise price times the number of option shares, and it is said to be “in the money.” For example, if you have an option to buy 1,000 shares, the company’s stock is worth $10 per share, and your exercise price is $0.10 per share, the value of your option is $9.90 per share for a total value of $9,900. If the price of the company’s stock is less than your exercise price, the value of your option is zero dollars per share for a total value of zero dollars, and it is said to be “underwater.”
Once your option period ends, typically after 10 years or when you leave the company, your option loses its value and is worth nothing. Your option may have a short grace period after you terminate employment during which you can exercise your option.
To use your option, you inform the company you wish to exercise your option to buy shares of the company’s stock. You then pay the exercise price for the number of shares you buy. For example, if you exercise your option to purchase 1,000 shares with a strike price of $0.10 per share, you pay the company $100 for those shares. Your stock option gives you the right but not the obligation to buy shares of the company stock. You don’t have to exercise your option. It’s up to you to decide whether and when to exercise your option.
Stock options are normally subject to vesting provisions designed to encourage employees to stay with the company. Vesting means you may exercise your option only after you have worked for the company the required time. Stock options commonly vest monthly over four or five years with a one-year “cliff.” A one-year cliff means that 12 months of vesting complete at the end of the first year. Vesting then continues monthly. As you vest, you gain the right to buy a number of shares proportional to vesting completed. For example, if you have a stock option on 1,000 shares and you have completed two of four years’ required vesting, then 500 shares are vested and you can exercise your option to buy those 500 shares.
Once you exercise your option and buy shares (typically after they have vested), you can hold the shares or you can sell them. Selling the shares typically requires that the shares be tradable on a public stock exchange, such as after a startup company has had its initial public offering (IPO) of stock or as with a mature company whose stock has been trading publicly for many years. Under some circumstances, you may be able to sell shares of private company stock. You will owe income tax once you exercise your non-qualified stock option. For this reason, many option holders sell at least enough shares when they exercise their options to pay the tax owed. Another common approach is a same-day exercise and sale, in which all exercised shares are sold immediately once they are purchased.
With an acquisition of your company, your option shares may be exchanged for shares of the acquiring company or you may be given cash for your shares and “cashed out.”
Once you exercise your non-qualified stock option, the difference between the stock price and the strike price is taxed as ordinary income. This income is usually reported on your paystub. There are no tax consequences when you first receive your non-qualified stock option, only when you exercise your option. Also, while there are no direct alternative minimum tax (AMT) consequences to exercising a non-qualified stock option (as there are for ISOs), higher reported income may subject you to AMT.
When you exercise your option and buy shares, your cost basis in those shares is the stock price on the day you exercised. When you later sell your shares, taxation follows the normal rules for gains and losses on investments. If you hold the shares for one year or more, any gain is taxed at the favorable long-term capital gains rates. If you hold the shares for less than one year, any gain is taxed at your ordinary income tax rates, which are usually higher.
Some pre-IPO companies have stock option plans that allow option holders to exercise their stock options before they vest. Early exercising private company stock options in conjunction with making a Section 83(b) tax election can convert a large portion of taxable income from ordinary income into capital gain. This will reduce taxes paid. With an 83(b) election, you have your option taxed at early exercise before the company price appreciates and before the option vests. In this way and if you hold the option shares for at least one year, only a small or even no amount of the option’s increase in value will be taxed as ordinary income, and the bulk of any gain will be taxed at long-term capital gains tax rates.
If you have non-qualified stock options, be sure to understand their basic features such as exercise price, vesting schedule, early exercise availability, grace period on termination, and end date. Also be sure to understand the tax consequences of exercising your options and selling shares to aid in your overall tax planning.
Although this post discussed the many differences between ISO and NSO, one important similarity is that in each case, the stock option must be granted with an exercise price that is no less than fair market value on the date of the grant.
This is a requirement of great importance with potentially drastic tax consequences. ISO and NSO are subject to substantial tax penalties in the event a stock option is granted below fair market value.
And please, always refer to your lawyer, accountant and financial advisor on all matter related to equity, contracts and taxes.