The Difference Between an ISO and NSO

What is the difference between a Qualified Incentive Stock Option (ISO) and a Non-Qualified Stock Option (NSO)?  While the short answer is tax implications, the long answer can be very complicated.  The “qualification” refers to the special tax treatment that an ISO receives from the IRS.

An ISO can only be granted to employees. Additionally, no regular federal income tax is recognized upon exercise of an ISO.  An NSO can be granted to anyone, including employees, consultants and directors. Only ordinary income is recognized upon exercise of an NSO based on the excess, if any, of the fair market value of the shares on the date of exercise over the exercise price.  Exercise of an NSO by employees will also be subject to a tax withholding.

 

NSO

Tax qualification requirements:

There are no specific tax requirements for an NSO, but an NSO granted with an option price less than the fair market value of the stock at the time of grant will be subject to taxation on vesting and penalty taxes under Section 409A.

The tax implications to an individual for exercising an NSO are as follows:

On date of exercise of option:

  • The option holder is taxed on any spread gain.
  • Ordinary income tax rates apply, plus employment tax rates if the option holder is an employee.

On date of sale of stock:

  • The option holder is taxed on any gain that accrues following the date of exercise.
  • Capital gains rates apply.

The tax implications to the company for an employee exercising an NSO are as follows:

The company is able to take a compensation deduction equal to the amount taxable as ordinary income to the option holder on the date of exercise. The company, however, will have to pay its share of employment taxes upon exercise.  The company will also have an obligation to collect tax withholdings and pay such amounts to the tax authorities.

 

ISO

Tax qualification requirements:

The requirements when exercising an ISO are more complicated.  In order to qualify, the following requirements must be met:

  • The option price must at least equal the fair market value of the stock at the time of grant.
  • The option cannot be transferable, except at death.
  • There is a $100,000 limit on the aggregate fair market value (determined at the time the option is granted) of stock which may be acquired by any employee during any calendar year (any amount exceeding the limit is treated as a NSO).
  • All options must be granted within 10 years of plan adoption or approval of the plan, whichever is earlier.
  • The options must be exercised within 10 years of grant.
  • The options must be exercised within three months of termination of employment (extended to one year for disability, with no time limit in the case of death).

The tax implications to an individual for exercising an ISO are as follows:

On date of exercise of option:

  • No ordinary income tax and no employment taxes
  • Any spread gain will be treated as income for purposes of calculating alternative minimum tax (AMT), unless the option holder sells or disposes of underlying stock in same calendar year as exercise.

On date of sale of stock:

  • If the sale occurs both more than two years after option grant date and more than one year after the date of exercise (the ISO holding periods), the option holder is taxed at long-term capital gains rates on the difference between the sale proceeds and the purchase price paid (plus any amounts taxed as ordinary income for AMT purposes). An earlier sale or other disposition (a “disqualifying disposition”) will disqualify the ISO and cause it to be treated as an NSO, which will result in ordinary income tax on the excess, if any, of the lesser of (1) the fair market value of the shares on the date of exercise, or (2) the proceeds from the sale or other disposition, over the purchase price. Any additional gain will be taxed at capital gain rates.

There are many potential pitfalls in determining tax implications.  Some of these include determining the impact of the Alternative Minimum Tax (AMT); determining the tax withholdings, including for Medicare; estimating any quarterly payments; and estimating capital gains taxes.

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