Stock option is a great way to motivate employees and consultants. Stock options give the right to purchase a set number of shares in the future, after the company’s stock has (hopefully) become more valuable, at a lower price set today. 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 type of stock options: The Incentive Stock Option (ISO) and the Nonqualified Stock Option (NSO).
What’s The Difference Between an ISO and an NSO?
1. 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.
2. 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 illiquid stock just yet.
3. 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.
4. 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.
5. 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.
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.