Both ISOs and NSOs are types of stock options that may be granted to the service providers of a corporation. ISO is short for Incentive Stock Option, and NSO (or sometimes NQSO) is short for Nonqualified Stock Option. An option granted to a service provider must meet specific requirements, which are detailed in the U.S. tax code, to qualify as an ISO. If an option qualifies as an ISO, then it is eligible, at various stages of the option’s lifecycle, for different tax treatment than if it were an NSO. If an option fails to meet the requirements to be qualified as an ISO, then it must automatically be treated as an NSO.
Due to complicated legal and tax issues associated with stock options, which may affect both the issuing company and the recipient of options, a company should consult with its attorneys and tax advisors prior to granting options to obtain up-to-date advice.
Here is a summary of some of the key requirements of ISOs and differences between ISOs and NSOs:
|Incentive Stock Options (ISOs)||Nonqualified Stock Option (NSOs or NQSOs)|
|Eligible recipients||Employees only||Any service provider (e.g., employees, independent contractors, including advisors and consultants, and non-employee members of a corporation’s board of directors)|
|Exercise price (or strike price) requirements||To qualify as an ISO, the exercise price of the option must be at least the fair market value (FMV) of the underlying stock at the time of grant.|
However, if the recipient of the option owns stock possessing more than 10% of the total voting power of the corporation, then the exercise price of the option must be at least 110% of the FMV of the underlying stock at the time of grant.
|None. However, there are certain onerous tax consequences and penalties imposed under Section 409A of the U.S. tax code on options granted with an exercise price less than the FMV of the underlying stock at the time of grant.|
|Other Limitations||Only up to $100,000 worth of ISOs (determined by reference to FMV at the time of grant) from an employer corporation may become exercisable (i.e., vest) for an individual in a calendar year. Any options in excess of $100,000 that become exercisable are treated as NSOs.|
Options intended to qualify as ISOs must be:
Options intended to qualify as ISOs cannot be transferable, except upon death.
|Taxation upon grant or upon vesting||No taxation upon grant. No taxation upon vesting.||No taxation upon grant. No taxation upon vesting (unless the option is granted with an exercise price below FMV at the time of grant and is therefore nonqualified deferred compensation under Section 409A of the U.S. tax code).|
|Taxation upon exercise||No ordinary income taxation upon exercise. However, the difference between an ISO’s exercise price and the FMV at the time of exercise is treated as a preference item for purposes of the Alternative Minimum Tax, unless the underlying stock is sold within the same calendar year as exercise (but see the discussion of a disqualifying disposition below).||Yes. The difference between an NSO’s exercise price and the FMV at the time of exercise is taxable as ordinary income upon the exercise of an NSO.|
|Taxation upon sale of stock underlying the option||Yes. The taxation of a sale of stock exercised from an ISO depends on whether the sale is a “qualifying” or “disqualifying” disposition:|
Additional complication arises if there is a disqualifying disposition of an ISO that is exercised prior to vesting of the underlying stock (i.e., if the option were granted as an early exercisable ISO). In the event of an early exercise of an ISO followed by a disqualifying disposition, ordinary income would be recognized on the difference between the exercise price and the value of the stock at each vesting date, and capital gains would be recognized equal to the difference between the fair market value of the stock at each vesting date and the price at which the stock is sold. Also, in such a situation, the clock for long-term capital gains treatment would begin on the vesting date of the stock, and not the date of early exercise.
|Yes. The difference between the cost basis of the stock exercised from an NSO (i.e., the cost to exercise the option, plus the ordinary income recognized upon such exercise) and the price at which the stock is sold is taxable at applicable short- or long-term capital gains rates depending on how long the shares of stock were held before the sale.|