In discussing incentive stock options vs non qualified stock options, it's important to weigh the differences between them. Incentive stock options are also called ISOs or statutory stock options. Nonqualified stock options are also known as NQOs or non-statutory stock options. While there are key differences between the two, they also have a lot in common.

Incentive Stock Options and Non-Qualified Stock Options

Stock options offer rewards as well as risks for employees. Restricted stock units are awarded to employees, but they must buy ISOs and NQOs. In general, it's riskier to exercise stock options at private companies vs public ones.

In a private company, employees may have fewer options in recouping their investment because the company can restrict when (or even if) shares can be sold.

You should understand how various stock options work and how your choice will impact your particular tax situation before you exercise the options available to you.

After vesting is complete, individuals can purchase a set number of shares of the company's stock at a predetermined price, known as the strike or exercise price.  Stock options grant employees the right to purchase shares, but it's not an obligation for them to do so.

ISOs have the potential for favorable tax treatment. If a stock option isn't an ISO, it's typically referred to as a nonqualified stock option. NQOs don't qualify for special tax treatment. The favorable tax treatment is the main advantage of ISOs for employees, and this includes long-term capital gains and no recognition of income when they exercise their options.

In the usual exit by acquisition situation, employees exercise their stock options and cash out. Their stock options are automatically defaulted to NQOs and they receive no special tax rates.

In practice, there's no material difference between ISOs and NQOs. However, ISOs may have the advantage in situations where employees should reasonably exercise and hold (for instance, the company goes public).

The tax regulations for option grants and exercises are very complicated and can change at any time. Any company which is thinking about option grants or individuals who are eligible to receive grants should consider consulting with their tax advisors and/or attorneys before making any decisions.

About Incentive Stock Options

When the current stock value is less than the strike price, incentive stock options are said to be  "underwater." ISOs are only for employees, so a member of the company's board of directors who is not a company employee isn't eligible to receive an ISO.

ISOs are issued according to a stock option plan that's been approved by shareholders and the board of directors. The option cannot be transferred. From the date the option is granted, the exercise period can't be longer than 10 years.

At the time the option is granted, the exercise price can't be less than the fair market value. Individuals must exercise their options within three months of leaving the company. This can be extended to twelve months for disability. There's no time limit in the event of death.

ISOs tend to be more complicated and harder to understand for a number of reasons, including the following:

  • The annual limitation
  • The two holding periods
  • The restrictions on eligibility
  • The rule about being more than a 10 percent shareholder

About Non-Qualified Stock Options

NQOs are also considered "underwater" when the current stock value is lower than the strike price. NQOs are open for anyone, so independent contractors as well as employees are eligible. The board of directors must approve NQOs in a written agreement.

When an individual exercises his or her options, this income is subject to employment taxes and tax withholding. NQOs are easier for companies to have just one type of award. They're also more transparent than ISOs because it's easier to calculate the amount of tax withholding on excess.

While special tax treatment is an attractive incentive, it shouldn't be the only factor someone considers in stock options. Due to the complexity of tax law and how quickly laws can change, it's always a good idea to get the most up-to-date information from experts in the tax and financial fields. This is one of the best ways to protect your valuable investments.

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