The difference between ISOs & NSOs

Stock options granted to eligible individuals may be incentive stock options (ISO) and nonqualified stock options (NSO).

 

Incentive stock options can be granted only to the employees of the company. Other qualifications:

·         Its term cannot be longer than 10 years.

·         If a grantee owns more than 10% of the company, this term is reduced to 5 years.

·         The option price must be set at a fair market value of the stock when it is granted. The option is non-transferable until death.

·         There is a $100,000 limit on the aggregate fair market value (determined when the option is granted) of stock, which any employee can get during any calendar year (any amount exceeding the limit is treated as a NSO).

·         The options must be exercised within three months after employment ends (increased to one year for incapacity, with no time limit in the case of death).

 

ISO allows an employee to postpone payment of taxes on any gains he might realize until the stock is actually sold. When option is granted to the employee or timely exercised it is not considered a taxable transaction. However, the change in the value of the stock at exercise and the exercise price is a point of adjustment for uses of the alternative minimum tax. When the stock is later sold any gain or loss will be treated as a long-term capital gain or loss. Gain or loss is the difference between the amount received from the sale and the amount paid on exercise. Disqualifying disposition destroys favorable tax treatment.

 

Nonqualified stock options can be granted to anyone (independent contractors, consultants, partners). There are no additional requirements or qualifications as in case with ISOs. The tax treatment, however, is less favorable.

 

A person recognizes taxable income at the time the option is exercised and stock is issued. Even though the stock is not sold, but held by that person. The tax basis is the difference between the market value of the stock at the time of exercise and the exercise price a person actually paid. Any gain is treated as ordinary income, not like long-term gain, and taxed at the relevant rate. Moreover, since it is treated as ordinary income, it is subject to employment taxes withholdings. The receiver has to pay taxes on any gains he received at the time the option is exercised and stock is issued and the company has to pay employment taxes. When the stock is later sold, the gain or loss will be a capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).

 

Here is a side-by-side comparison of tax implications of ISOs and NSOs.

 

 

ISO

NSO

Employee exercises options

No tax

Ordinary income tax (28% - 39.6%)

Employer gets tax deduction?

No deduction

Tax deduction upon employee exercise

Employee sells options after 1 year or more

Long-term capital gains tax at 20%

Long-term capital gains tax at 20%

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