Stock options are one of the most common forms of equity compensation that a company can use to incentivize its workforce. You can find a general overview of stock options in this article. When a company issues options to US employees, there are two types it can choose from: incentive stock options (ISOs), which qualify for special tax treatment under the United States Internal Revenue Code, and non-qualified stock options (NSOs), which do not.
How do I determine whether to grant ISOs or NSOs?
Under the right conditions, ISOs can result in lower taxes for the optionee.
NSOs are generally taxed (for regular federal income tax purposes) upon exercise in an amount equal to the difference between the exercise price and the fair market value (FMV) of the shares on the date of exercise. ISOs, on the other hand, are not taxed (for regular federal income tax purposes) until the optionee sells or otherwise disposes of her shares.
To illustrate this point, consider an early stage company that grants options to an employee at an exercise price of $0.10 per share (the FMV of the company’s common stock at the time the option is granted). As the company grows, its shares become more valuable. By the time the option fully vests, the shares underlying the option are worth $1.00 each and the employee exercises the option (i.e. pays $0.10 for each share). The $0.90 difference between the FMV of the shares at exercise and the original exercise price is sometimes referred to as the “spread”. If the grant is an NSO, the employee pays federal income taxes on $0.90 of income per share at exercise, even though the employee has not sold any shares. If the grant is an ISO, there is no federal income tax due at exercise.
If the employee sells the shares three years later, she would owe federal income taxes at the long-term capital gains rate on either (1) the difference between the value at exercise and the value at sale, for an NSO, or (2) the difference between the exercise price and the value at sale, for an ISO.
Why wouldn’t I always grant ISOs?
The preferential tax treatment afforded to ISOs has strings attached:
- Only employees can receive ISOs, whereas NSOs may be granted to any service providers (e.g., employees, directors, consultants, and advisors).
- ISOs must be exercised within three months following termination of employment (even if the holder continues providing services in some other capacity).
- ISOs must be held for more than two years after grant and the shares obtained upon exercise of an ISO must be held for more than one year after exercise.
- ISOs must be exercised within ten years of the grant date.
- The fair market value of ISOs that are exercisable for the first time in any calendar year may not exceed $100,000 based on the fair market value at the time of grant (any excess will be treated as an NSO).
- Beware early exercise provisions where all options become exercisable immediately after grant! They can have a big impact on how many shares are eligible for ISO treatment.
- ISOs are only transferable upon the death of the recipient.
- ISOs granted to significant shareholders (>10%) must have an exercise price of at least 110% fair market value and must be exercised within five years after the grant date.
- ISOs can only be granted by an entity taxed as a corporation.
I tried to grant ISOs but didn’t meet all of those requirements. Now what?
If your ISOs don’t meet these requirements, the option grant itself is still valid, and will automatically be treated as an NSO, even if the company intended otherwise.
Options granted as ISOs frequently do not qualify for the preferential tax, either because the required holding period is not met or the ISO is never exercised and is, instead, cashed out in connection with an acquisition of the company. An ISO that is cancelled for a cash payment is subject to ordinary income taxes for federal purposes, similar to a cash bonus or to the cancellation of an NSO for a cash payment.
Summary of ISO vs. NSO Differences
Please refer to the below chart for a summary of some key differences between ISOs and NSOs.
|Incentive Stock Options (ISOs)||Non-Qualified Stock Options (NSOs)|
|Granting Entity||Corporations* only
*Includes any entity taxed as a corporation for US federal tax purposes
|Corporations, LLCs, Partnerships|
|Eligible Recipients||Employees only||Any service provider (e.g. employees, advisors, consultants, directors)|
|Tax at Grant||No tax event||No tax event|
|Tax at Exercise||Typically no tax event*
*Note that the difference between the FMV and the exercise price is treated as income for purposes of calculating the optionee’s Alternative Minimum Tax (AMT) and could result in AMT taxes
|“Spread” taxed as ordinary income for federal income tax purposes|
|Tax at Sale||Sale price minus exercise price taxed as long-term capital gain for federal income tax purposes||Sale price minus FMV at exercise taxed as capital gain for federal income tax purposes|
|Granting Entity Deduction||No deduction||Granting entity entitled to a tax deduction equal to the amount of ordinary income recognized by the grantee upon exercise|
to achieve long-term capital gain rate for federal income tax purposes
|Must hold stock for:
||Must hold stock for:
|Exercise Following Termination||Must be exercised within 3 months (longer following death/disability)
Unless a shorter period is set by the plan
|Set by the plan/agreement
No later than the expiration date of the option
|Value Restrictions||Only $100,000 can become exercisable in any one calendar year per employee||No limit|
|Transfer||Only upon death||Set by the plan/agreement|
|>10% Stockholders||Exercise price must be at least 110% of FMV and option term must be 5 years or less||Exercise price must be at least FMV and option term set by plan/agreement|
|Expiration||No more than 10 years from grant date (or, in the case of 10% stockholders, no more than 5 years, as noted above)||Set by the plan/agreement|
Thanks to Sam Lipson for input into this article.
Last reviewed: November 3, 2020