What are Incentive Stock Options (ISOs)?
Incentive Stock Options (ISOs) are a type of employee stock option that offers tax advantages for the recipient, primarily in the form of delaying tax liability until the stock is sold, rather than when it’s exercised. ISOs can only be granted to employees of the company.
How Are ISOs Taxed?
The main benefit of ISOs is the favorable tax treatment:
- No ordinary income tax upon exercise.
- Taxes are paid when the stock is sold, and if held for more than one year after exercise (and two years from grant date), the gains are taxed at long-term capital gains rates, which can be significantly lower than ordinary income tax rates.
What are Non-Qualified Stock Options (NSOs)?
Non-Qualified Stock Options (NSOs) are more flexible than ISOs. They can be granted to anyone—employees, contractors, board members, etc. They do not offer the same tax benefits as ISOs.
How Are NSOs Taxed?
- The difference between the exercise price and the fair market value at the time of exercise (the spread) is treated as ordinary income and taxed as such.
- Any subsequent gains (or losses) from selling the stock are taxed as capital gains or losses.
What’s the Difference Between ISOs and NSOs?
| Aspect | ISO | NSO |
|---|---|---|
| Eligibility | Only employees. | Employees, contractors, advisors, etc. |
| Tax Treatment | Favorable; taxes deferred till sale. | Taxed as ordinary income upon exercise, capital gains upon sale. |
| Exercise Timing | Often requires longer holding periods for tax benefits. | Can be exercised immediately. |
| Limitations | Comes with several restrictions for tax benefits. | Fewer restrictions, more flexibility. |
How Do I Determine Whether to Grant ISOs or NSOs?
Your decision may be influenced by:
- Eligibility: If the recipient is a non-employee, NSOs are the only option.
- Tax considerations: ISOs offer better tax benefits to recipients, but may have AMT implications.
- Company’s financial strategy: NSOs might provide tax deductions for the company.
ISO vs NSO: Which One is Right For You?
The decision boils down to individual and company preferences, tax strategies, and who the recipient of the options will be.
When to Choose an ISO
- When providing options to employees.
- When seeking to offer tax benefits to the recipients.
- When the company aims to incentivize longer-term holding of shares.
When to Choose an NSO
- When offering options to non-employees.
- When the company seeks tax deductions.
- For flexibility without ISOs restrictions.
Why Wouldn’t I Always Grant ISOs?
While ISOs offer tax advantages, they come with stricter rules and can trigger Alternative Minimum Tax (AMT) for the recipient. They also lack the corporate tax deduction benefit that NSOs offer.
What are the Requirements for ISOs?
- Recipient must be an employee.
- Exercise price must be at least equal to the fair market value of the stock at the time of grant.
- Must be granted under an approved stock option plan.
- Shares acquired via ISOs must be held for at least 1 year after exercise and 2 years after the grant date to qualify for favorable tax treatment.
How ISOs and NSOs Work
Both options provide the right to purchase company shares at a predetermined price. The key differences lie in their taxation, eligibility criteria, and restrictions.
Which is Best for Startups?
There’s no one-size-fits-all answer. ISOs can attract employees with favorable tax treatments, but NSOs offer more flexibility. Startups typically grant a mix, depending on their financial strategies, goals, and the desired recipients. It’s essential to consult with financial and legal experts when determining an equity compensation strategy.
