ISOS vs NSOS: A Comparative Analysis

|

Issuing stocks by way of equity compensation is one of the most common ways in which a startup can pay its workforce. When issuing stock to US employees, there are two main options to choose from:

  1.   Incentive Stock Options (ISOs)
  2.   Non-qualified Stock options (NSOs)

ISOs can only be granted to employees, whereas NSOs can be granted to a wider range of people associated with the business, such as directors, consultants, advisors as well as employees. Despite the fact that NSOs are of wider applicability, ISOs are preferred form of stock option for most startup This is because they enjoy special tax treatment under the United States Internal Revenue Code, whereas NSOs do not.

ISOS VS. NSOS: WHAT TO GRANT, AND WHEN

Under certain circumstances, ISOs come with more tax benefit for the optionee.

For the purpose of federal income tax, the way SOs are taxed upon exercise is by determining the difference between the fair market value (FMV) and the exercise price (also known as strike price) at the moment of exercise. This amount may sometimes be zero, but not always. This amount will be taxed as ordinary income tax rather than capital gains tax. By way of comparison, ISOs are not taxable under regular federal income tax unless the optionee parts with their shares by way of sale or transfer.

For instance, let us assume a startup issues options to an employee at the exercise price of $0.20 per share (this is also the FMV of the company's common stock when the option is granted). With the passage of time, the company stock becomes more valuable. By the time the option fully vests, the stock is valued at $1.00 dollar. Let us assume the employee now exercises the option, i.e., and pays $.20 per share. The S.80 difference between the fair market value of the shares at exercise and the original exercise price is also known as the "spread". If the employee has been granted an NSO, then he stands to pay federal income taxes of on $.80 of income per share, notwithstanding the fact that he has not sold aby shares. If the grant is an ISO, no tax is due at this point as long as the grantee does not sell. Assuming the employee who was granted an ISO chooses to sell the shares 3 years later, they would be taxed at the long-term capital gains rate on the difference between the exercise price and price at sale. Meanwhile, an employee who was granted an NSO would have long term capital gains liability on the differential between the value at exercise and the value at sale.

ARE THERE ANY DRAWBACKS OF GRANTING ISOS?

The preferential tax benefits of ISOs are undeniable, but there are certain instances in which granting ISOs may not be the best option:

  1. ISOs are available to employees only. Which means ISOs are not available to individuals that work in upper management or executive positions. To avoid this issue a startup should consider offering NSO's which can to both groups' employees and upper-level positions making them more versatile.
  2. Once the grantee of an ISO ceases to be an employee, they are required to exercise their ISO within three months of termination of employment. This is true even if the former employee continues to provide services in some other capacity.
  3. ISO must be held for more than 2 years after being and the shares obtained on exercising the option must be held for over a year.
  4. ISOs need to be exercised within 10 years of being granted.
  5. When it comes to ISOs being exercised for the first time in any calendar year, their fair market value cannot exceed $100,000. Any excess will be considered an NSO for tax purposes. Be careful of early exercise provisions which force you to exercise them immediately after they're granted - this will directly impact how many shares can be considered for preferential ISO treatment.
  6. The only instance in which ISOs become transferrable are upon the death of the recipient.
  7. ISOs that are granted to shareholders with greater than 10pc shareholding must have an exercise price which is at least 110% of the FMV. It is mandatory for them to exercise the ISOs within 5 years of granting.
  8. ISOs can only be issued by corporations.

In the event of your grant not meeting the criteria necessary to qualify as an ISO, the grant will remain valid, and it will automatically be treated as an NSO despite the company's intentions to the contrary.

It is very common for properly granted ISOs to eventually not meet the criteria necessary to qualify for tax benefits. This is perhaps because the holding period is not satisfied, or the ISO was never exercised but rather cashed out as a part of acquisition. ISOs cancelled in favor of cash payment will be subject to ordinary income tax principles, just like a cash bonus is. 

Disclaimer: This article is made available for educational purposes only, to give you general information and a general understanding of the law, not to provide specific legal advice. By using this article, you understand and acknowledge that no attorney-client relationship is formed between you and The South Texas Business Lawyers, nor should any such relationship be implied. This article should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.

Discover the Secret to Solving Any Legal Challenge in Your Business- FREE Private Facebook Group

Don't let legal issues destroy your business - get the legal support you need to stay PROACTIVE in this Free Private Group, "As A Texas Business Attorney", Limited Slots Available. 

Fill out your information here and we will get you in!

Share To: