A nonstatutory stock option vs incentive stock option refers to the differences in these stock options, which include who can receive these options and how the options must be exercised.

The Differences Between ISOs and NSOs

Incentive stock options, or ISOs, can only be given to full-time or part-time employees. Other rules have to be followed in order to maintain ISO status, such as stockholders approving the option plan. An ISO has to be exercised within 90 days of employment termination.

ISOs have dollar limits, so a taxpayer has a limited amount to exercise in a calendar year. Special rules apply for ISO grants to holders that own 10% or more in a company.

When the ISO is granted, there's no tax on the individual holding the option. Also, when the optionee exercises his or her option, there's no tax. However, at the time of exercise, the spread may be subject to the Alternative Minimum Tax (AMT).

If the holding period is met for an ISO — after exercise and upon the sale of shares — providing it's either one year from exercise or two years from the option grant date (whichever is longer), the spread will be taxed at a long-term capital gains rate. After exercise, upon the sales of ISO shares, if the holding period hasn't been met, the spread at exercise will be taxed at the ordinary income tax rate.

NSOs may be granted to the following:

  • Employees
  • Non-employees, such as directors and consultants

If an option attempts to be an ISO but fails, it's taxed as an NSO.

Typically, there's no tax on NSO grants. Upon exercise, ordinary income tax rates apply. It's subject to FICA and Medicare, and employees are subject to tax withholding. Upon the sale of NSO shares after exercise, any appreciation over the value will be taxed at capital gains rates. This may be short- or long-term, depending on the holding period.

An ISO's or NSO's exercise price has be at least 100% of the fair market value of their underlying shares on the date that the option was granted. For an individual holder with more than 10% of the company, the exercise price for ISOs have to be a minimum of 110%. The option term can't be longer than five years.

Exercising Shares

When ISO shares are sold, the tax is determined by the difference between the original exercise price and the sale price.

At the time an NSO is exercised, ordinary income tax applies. The tax is determined by the difference between the fair market value of the shares and the exercise price.

To keep ISO treatment, these shares have to be held a minimum of one year following exercising the option. In addition, they must be held a minimum of two years from the date of the grant. If an individual sells shares before the completion of the holding periods, the ISO is then “disqualified.” For most purposes, it becomes an NSO. At this time, the company must treat the option like an NSO for withholding and accounting purposes.

With the exception of employment termination, employees usually wait to exercise until a market exists for the shares — such as in connection with a merger or after an initial public offering (IPO). They then choose to sell their shares soon after exercise, and this results in disqualification. Ultimately, this is the reason for a large number of ISO disqualifications.

Companies can take a tax deduction for compensation that's considered paid upon exercise. Because of this, some businesses prefer to grant NSOs.

Employees might prefer ISOs because they give them the chance to defer ordinary income tax until they sell the shares. They then have the potential to pay a lower tax rate. When ISOs are exercised, the alternative minimum tax isn't deferred.

A company may want to consult with outside accountants to understand the following differences between ISOs, NSOs, and disqualified ISOs:

  • Withholding
  • Accounting
  • Financial statements
  • Taxes

Individual recipients should also check with their personal tax advisors since everyone's tax situation is different. This is good advice for companies and individuals, since there are various implications depending on which option you use.

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