Employee Stock Options

ISOs & NSOs

By Jon Scott

Abstract: This article explains both Incentive Stock Options (ISO) and Non-qualified Stock Options (NSO). You will want to review this article if you are considering or expect to receive an offer that involves stock options.

Incentive stock options are awarded by a company to an employee, giving the employee the right to buy shares of the company’s stock at a defined–and usually reduced–price compared to the actual market value.

Non-qualified stock options (NSO) give employees the right to buy a set number of shares at a set price within a designated time frame. Often NSO are offered as alternatives to salary compensation. The price of the stock is most often the same as the market value of the shares on the grant date. If the stock is not bought within the designated timeframe, the employee loses the right to buy the stock at the set price.

Both ISOs and NSOs are subject to a vesting period, a period of time working at or with the company before the stock options are able to be exercised.

The difference between ISOs and NSOs is the fact that ISOs do not have the same tax consequences. Specifically, ISOs allow the employee defer taxation on the stock received from the date the stock was actually acquired until the sale of the stock. Additionally, ISO are taxed at capital gain rates on any realized gains above the grant price which are lower than income tax rates. However, there are requirements that must be met:

  • ISOs can only be granted to employees

  • ISO are subject to alternative minimum tax in the year exercised.

  • The employee, after acquiring the stock via exercise of the option, must hold the share for at least one day after the exercise date and two years after the grant date.

  • The grant price must be greater than the fair market value of the company stock on the date the option was granted

  • The ISO needs to be exercised within 10 years of the grant date.

  • The fair market value of stock exercised stock cannot exceed $100,000 per year.

The tax consequences for NSO are substantially different from a taxation perspective:

  • Taxes are due as soon as the stock option is exercised and since NSOs are considered income, meaning they are taxed at the income tax rate of the recipient

  • NSOs gains (from exercise date to sale) are also taxed when they are sold at the income taxed level.

  • NSOs are eligible compensation options for outside service providers such as consultants, advisors, and board directors.

  • NSO aren’t subject to a dollar limit per year, and may be granted on top of ISOs.

Why do companies issue ISO and NSO?

ISOs are meant to attract and retain talented employees. Generally, ISO are only granted to top-tier and/or key employees. ISO are typically offered upon a job offer or as an incentive to convince an employee to remain at the company.

NSOs are also incentives to keep employees but also a method of deferred compensation for employees. The word compensation is used, since NSO are taxed the same as compensation. The idea is that over time the company’s stock will increase which will lead to additional compensation once the shares are sold. NSOs are also more advantageous for the company since they allow the company to take tax deductions when the employee, consultant, etc. exercises the stock option.

It is not unusual for a compensation option to have both ISOs and NSOs

What qualifying and disqualifying dispositions

When the holding period requirements are met, the sale of ISO is called a qualifying disposition. At this point, the sale would be subject to long-term capital gains between the grant price and the sale price.

When the holding period requirements are not met, the sale would be a disqualifying disposition. At this point, the sale would not be subject to long-term capital gains tax and instead subject to the higher rate ordinary income taxes. In this case the ISO is no different than a NSO.

When should you exercise your ISO

This is the complicated part, and depends on your company’s situation. Let’s run through some situations:

  • If your company is executing a IPO you will want to exercise your ISO 12 months before you sell them. However, you will need to pre-pay the part of the taxes the moment you exercise.

  • If you are at a growing startup, the best time to exercise your exercise your ISOs as soon as possible. The benefits are long-term capital gains tax savings and less cash upfront when you exercise.

Exercising can be very expensive (often in the hundred of thousands for key employees at successful startups) and to reap the main tax advantages you will need to pay the alternative minimum tax and hold onto the stock for at least 12 months. It will be absolutely critical to discuss your ISO with a financial advisor.

When should you exercise your NSOs

Unlike ISOs, generally the best time to sell your NSO are as soon as they are exercised since there is no tax advantage to holding them. However, if you expect the shares to appreciate significantly, you can hold the shares. Gains (profits) from the exercise date to the sale date will be taxed at long-term capital gains tax rate.

How do ISOs and NSOs fit into my total compensation?

ISOs are generally reserved for key employees and top tier performers. Rarely, especially at a young age, will an individual have options for ISOs, and you will want to discuss with a financial professional.

NSOs are more common than ISO and function differently. NSO are considered deferred compensation, and since it is usually best to sell them as soon as they are exercised, NSO function much more like income than ISOs. NSO are a great option if you believe the company will be successful, the company success will be reflected in the stock price at the end of the vesting period, and you don’t need the cash now. However, NSO should be used as a negotiating chip to increase your total compensation–it is generally not wise to trade your salary for NSOs. Instead, you may choose to reduce your salary but acquire NSOs that increase your total compensation beyond what your salary alone would’ve been.