Non-Qualified Stock Options (NSOs) and Incentive Stock Options (ISOs) are the two types of stock options issued by startups. They are offered to employees and service providers as part of their compensation, and are effective tools to attract and retain talent.
While there are different types of employee equity grants, employee stock options are the most common ones used by startups. This guide will give you an overview of how stock options operate, providing you practical examples of ISOs and NSOs and how they’re taxed.
Non-qualified Stock Options (NSO)
Non-Qualified Stock Options or NSOs are a type of stock option grant that give the recipient the right to acquire stock in a company in exchange for payment of a predetermined purchase price (commonly known as the ‘strike price’ or the ‘exercise price’).
This type of option can be granted to employees and non-employees (such as consultants, contractors, members of the board of directors). NSOs are ‘non-qualified’ because they do not receive favorable tax treatment.
Incentive Stock Options (ISO)
ISOs, on the other hand, are a type of stock option that qualify for special tax treatment; including not having to pay tax on exercise of the option and potentially paying a lower tax rate (if certain conditions are met).
ISOs, as the name goes, are used as an incentivizing tool for new and existing employees to attract talented individuals. Unlike NSOs, however, this type of option can only be granted to employees.
How to choose which one to grant your startup team
Although ISOs can result in lower taxes for your employees, the preferential tax treatment comes with a couple of strings attached. These include:
- ONLY Employees can receive ISOs. Whereas NSOs can be issued to any service providers (directors, contractors, advisors, employees)
- ISOs must be exercised within 3 months of termination of employment
- ISOs must meet the Holding Period requirements before a sale to gain beneficial tax treatment. That is, the ISO stock options must be held for more than 2 years after they’ve been granted, and more than 1 year after exercise
- ISOs must be exercised within 10 years of the grant date
- ISOs cannot be transferred until death of the recipient
- If ISOs are granted to employees that are 10% owners of the company, then:
- (1) the strike price must be 110% of the fair market value of the shares on the date of grant; and
- (2) the options must be exercised within 5 years of the grant date
- ISOs can only be issued by companies that are taxed as corporations (C- and S-corps) for US federal tax purposes
- The Fair Market Value (FMV) of ISOs that are exercisable in the first year cannot exceed $100,000 at the time of grant (any stock options over the threshold will automatically be treated as NSOs)
- The ISOs must be issued pursuant to a written plan approved by the shareholders
If any of the above requirements are not met, the options will automatically be treated as NSOs.
Stock options that are granted to US recipients frequently fall short of these requirements. Most commonly, this is due to the (miss) timing of the exercise. For example, either the Holding Period had not been met OR the employee didn’t exercise the option and, consequently, their options were wrapped up as part of a sale or acquisition of the company.
Unless employees are vigilant or the issuing company gives its employees proper notice and warning of their requirement to exercise their options prior to a sale event, which in any event, is near impossible to do a year out, timing an exercise is like shooting tadpoles in a barrel (I’m terrible with idioms, so just go with it).
Tax implications of ISO vs NSO
Like NSOs, ISO stock options are subject to long-term capital gains if they are exercised and held for at least one year and have been held for a minimum of two years from the grant date.
If an option holder decides to sell their shares within a year of exercising them (for example, to cover the cost of exercise), the sale will not qualify for the ISO tax treatment and will be taxed as wage income on the difference between the FMV at the time of sale and the strike price. This is known as a ‘disqualifying disposition’. Instead, they’ll be taxed like NSOs and will be subject to wage income tax on the difference between the FMV of the shares at the time of sale and the strike price.
Tax implications on ISO, examples
If the Holding Period (more than 2 years after grant, and more than 1 year after exercise) is met, then the employee will recognize long-term capital gains income on the difference between the sale price minus the strike price on the date the shares are sold. Here is an example for when the Holding Period is met:
- In Year 1, employee is granted an ISO to acquire 10 shares at an strike price of $10/share.
- In Year 3, employee exercises the option and acquires all 10 shares when the share price is $50/share.
- In Year 5, employee sells the 10 shares for $100/share.
- The option is not taxed on the grant date.
- When exercised, no federal tax event occurs (note here - alternative minimum tax ‘AMT’ may apply on exercise. This is a separate individual tax determination in which the employee will need to seek advice from their tax advisor).
- The Company will also not be entitled to a federal tax deduction at the time of exercise.
- When the shares are later sold, the employee has a gain of $900 (i.e., $1,000 - $100) that is subject to the long-term capital gains tax rate.
If the Holding Period is not met, then the difference between the fair market value of the shares on exercise minus the strike price is considered wage income to the employee, but the employer is not required to withhold from such amount. The employer may claim a tax deduction for the income piece.
Any gain over the fair market value of the shares on exercise is subject to short or long-term capital gains tax depending on how long the employee held the shares.
Here is an example for when the Holding Period is not met:
- In Year 1, the employee is granted an ISO to acquire 10 shares at an strike price of $10/share.
- In Year 2, the employee exercises the option and acquires all 10 shares when the share price is $50/share.
- In Year 2, the employee sells the 10 shares for $100/share.
- The option is not taxed on the grant date.
- When exercised, no federal tax event occurs.
- Since the Holding Period is not met (i.e., the shares are sold in the same year they are acquired), the employee recognizes income of $400 (i.e., $500 - $100), which is taxed as wage income. The employee also recognizes a gain of $500 (i.e., $1,000 - $500) which is subject to the short-term capital gain tax rate.
- The employer may claim a tax deduction for the wage income piece of $400.
NSO are taxed on both exercise and sale. On exercise of the option, the ‘Spread’, being the difference between the FMV at the time of exercise and the strike price at the time of grant, are taxed as wages for employees or self-employment wages for non-employees.
Both types of wages are subject to regular income tax and employment taxes. If the stock is then sold within the first year of the exercise date, the option holder will pay tax on the ‘Gain’ (final sale price minus the FMV at the time of exercise) based on the short-term capital gains tax rate. If the option holder sells the stock and, upon exercise, has held them for a year, then the long-term capital gains tax rate will apply to the Gain.
Tax implications on NSO, example
- In Year 1, a service provider is granted an NSO to acquire 10 shares at an strike price of $10/share (valued at $100).
- In Year 3, the service provider exercises the option and acquires all 10 shares when the share price is $50/share (valued at $500).
- In Year 5, the service provider sells the 10 shares for $100/share.
- The option is not taxed on the grant date.
- When exercised, the service provider has income of $400 ( the ‘Spread’ i.e. $500 - $100) that is considered wages subject to income and employment taxes. The employer may claim a tax deduction for the $400.
- When the shares are later sold, the service provider has made a capital gain of $500 (the ‘Gain’ i.e., $1,000 - $500). Because the 1-year holding period has been met here, the Gain is subject to the long-term capital gains tax rate.
There are further tax rules that apply to NSOs which ensure that the Internal Revenue Code (“Code”) is satisfied. This involves Section 409A of the Code, which imposes a 20% excise tax penalty and interest penalties that are imposed against the option holder (not the employer) if the rules are not met.
An NSO will generally comply with Section 409A if the strike price of the NSO is at least equal to the fair market value of the stock on the date the option is granted. See our post here for further guidance on Section 409A.
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Exercising ISO vs NSO
When can you exercise NSOs or ISOs and when do they expire?
Given the purposive nature of ISOs, it is generally required for an employee to have worked in the company for a certain period of time before they are given the right to purchase their shares. This mechanism that ensures this is called a vesting schedule. Vesting Schedules are, generally, standardized across the stock option program. These conditions are (generally) contained in the option agreement or offer letter. The conditions can either be time-based (ie. with a 1 year cliff, and 2 year periodic vesting), or performance/milestone-based (ie. the company reaches $1 million ARR).
When do ISOs expire?
ISOs expire 10 years after the grant date. However, depending on the terms of the stock option program, a period called the “post-termination exercise period” (PTE) may be enforced after departing the company and there may be a shorter period of time that the options are exercisable within. If the options are not exercised within the PTE the opportunity to exercise will be lost ie. the options will ‘lapse’, and be returned to the option pool. Regardless of any PTE conditions, however, the ISO tax treatment is lost on any ISOs that are not exercised within three months of leaving the company and the options will be taxed as NSOs. Note here, the terms of the plan may provide that the three month expiration may be extended to one year in the case of an employee that terminates employment, for example, due to disability.
Similarly with ISOs, the exercise dates are usually set out by the employer in accordance with the Vesting Schedule. NSOs may be exercised as soon as the vesting conditions are met, however, this does not mean one has to exercise. Remember, there are tax implications to consider! At exercise, the strike price can either be paid in cash or, if sold at the same time, using a portion of sale proceeds. The latter option is known as a “cashless” exercise, however, the option holder may need to seek approval to do so by the company - so make sure to check with your program administrator.
When do NSOs expire?
NSOs do not (technically) have an expiration date. Although this can be varied by the terms of a company’s stock option program. Additionally, and as previously mentioned, on departure of the company, an employee is given a period to exercise any NSOs that have satisfied the vesting conditions. Again, if these vested options are not exercised before the PTE they will lapse.
In conclusion, which one is better for startups
The answer depends on your business circumstances and requirements. NSO and ISO have different use cases and each has its own pros and cons.
We've observed that most companies that use Cake generally issue NSO.
To summarize, NSOs are useful if you want to grant equity to non-employees like advisors or contractors. ISOs, on the other hand, are commonly used when granting equity to employees because of its tax advantages.
If you’re still unsure on which type of stock option to grant to your employees and you’d like to speak to one of our friendly neighbourhood attorneys, follow the link and fill out the form.