When it comes to compensating employees, companies have the option of either granting their employees stock options or restricted shares. Either of these forms of compensation is geared towards motivating employees and retaining top talents in the company. Here, our focus shall be on ISO vs NSO differences and similarities.
Before we discuss the differences and similarities between these two types of stock options, let us understand what each of them means. What are ISO and NSO?
What is ISO?
ISO stands for Incentive Stock Options. ISOs give employees the right to buy the shares of the company in which they work at a discounted price (grant price) within a stipulated period. They are mostly awarded to employees as part of a promotion package or in addition to their regular wages.
Incentive stock options are a type of stock option that is solely issued to company employees and are considered a great incentive by employees because they are often associated with low tax liabilities. They generally expire ten (10) years after they were issued but in a case where the employee’s appointment is terminated, the ISO usually expires after ninety (90) days although a few companies offer a longer expiration window. They are also known as qualified stock options or statutory stock options.
Features of ISO
- Incentive stock options cannot be transferred to another person except if the employee it was granted to dies. Simply put, they are non-transferable.
- The maximum fair market value (FMV) of ISO that can be exercised each year is one hundred thousand dollars ($100,000) based on the FMV at the time of grant. The time of grant is the date on which the ISO was granted to the employee.
- Only a company’s employees can be granted incentive stock options.
- Employees who retain at least ten percent (10%) of the company must pay a premium when exercising their ISO. The expiration date of ISOs granted to such employees is usually five (5) years after the grant date.
- The Internal Revenue Code (IRC) gives tax advantages to ISOs known as the Section 83(b) election. A form for this election is available and can be accessed on the SEC website.
- ISOs generally have a vesting schedule. This is a schedule that outlines the timeline and the number of shares that employee gets when certain conditions are met by the employee until they get full ownership of all the shares in the incentive stock option agreement.
What is NSO?
NSO stands for Non-qualified Stock Options. They are so-called because they do not qualify for the IRS section 83(b) election. They give those to whom they are issued the right to purchase the company’s shares at a predetermined price known as the exercise price within a preset period.
NSOs are a type of stock option that can be granted to employees as incentives. Additionally, they can be offered to investors or other individuals who offer services to the issuing company such as consultants, contractors, etc. They typically have a time-based vesting schedule after which they function as common shares of the issuing company. They are also known as nonstatutory stock options
Features of NSO
- Non-qualified stock options can be issued to employees as well as other service providers of the company.
- Most NSOs are transferrable.
- Non-qualified stock options have fewer conditions associated with them compared to incentive stock options.
- There is no cap on the maximum value of stocks that can be exercised yearly.
- They do not qualify for tax advantages in section 83(b) election.
ISO vs NSO differences
- Eligible recipients
- Termination of employment or service
- Disqualifying dispositions
- Granting entity
ISO vs NSO differ in all the ways listed above, we shall discuss each of these points further below:
Taxes for ISO vs NSO
- Withholding tax
- Time of payment
- Double taxation
Generally, the taxation of ISOs or NSOs occurs at exercise or sale but there are other events that could affect their taxation which we shall further discuss below:
Tax at the exercise of ISO vs NSO
When either ISOs or NSOs are granted, the agreement for the stock option usually specifies when the person can exercise it which is normally based on a vesting schedule. When the holder of ISO exercises their stock option, there is typically no tax event for the holder. However, if the difference between the option’s fair market value and its exercise price is above seventy-three thousand, six hundred dollars ($73,600) for individuals and one hundred and fourteen thousand, six hundred dollars ($114,600) for married persons filing jointly, it might be liable to the payment of Alternative Minimum Tax (AMT).
For most US states, the AMT is 0 but for Colorado, California, Minnesota, and Iowa, the AMT rate is 3.47%, 7%, 5.8%, and 7% respectively. However, individuals and couples whose income is in the ordinary tax income level are not subject to the AMT rate.
When holders of NSOs exercise their stock option, the issuing company gets a tax deduction on their income at the end of the year in which the NSO was exercised. Thus, making them a beneficial stock option to be granted by companies. Additionally, both nonqualified stock option holders, as well as the granting entity, get taxed at the ordinary income tax and payroll taxes on the spread between the fair market value and the exercise price.
Furthermore, when NSOs are exercised and the appropriate amount of income tax has been paid, the holder gets a reduction on the Alternative Minimum Tax (AMT) are supposed to pay on any ISO they exercise in that same year. As a result of this tax advantage, a lot of individuals who have both NSOs and ISOs exercise and sell the NSOs first while holding on to their ISOs. By doing so, they enjoy capital gains on them as well as reduced alternative minimum tax.
Tax at the sale of ISO vs NSO
The difference between the strike price (the price at which the ISO was granted) and the selling price is taxed as long-term capital gains. The long-term capital gains rate varies between zero to twenty percent (0 – 20%). The rate is valid only if the ISOs is held for more than a year after it was granted and for two years after it vests. ISO holders who sell them before it gets to a year after it was granted or before it gets to two years after vesting are taxed at the regular tax rate. This is because the gains on the sale are classified as ordinary gains.
When selling NSOs, taxes have to be paid on the difference between the grant price and the market value of the shares at the selling time. The difference is the gain resulting from the sale is taxed as personal income.
Payroll taxes for ISO vs NSO
The payment of payroll taxes also differs for ISOs and NSOs. Incentive stock options are usually not charged payroll taxes since they are charged the standard income tax when exercised. Nonqualified stock options on the other hand are charged payroll taxes when exercised. These payroll taxes include Social Security taxes, Medicare, and Federal Unemployment Tax (FUTA). The issued company is taxed on all the aforementioned while the holder is charged only on Social Security and Medicare.
Additionally, if a company that issued ISO or NSO is undergoing a Merger or Acquisition (M&A), both the ISO and NSO will be subject to payroll taxes and ordinary tax. However, holders of the ISO can exercise their stock option before the M&A, as this will make them save on having to pay payroll taxes. NSO holders on the other hand can not exercise their stock option in such a way
Generally, employees who have been granted ISOs have to file their taxes themselves. These payments are usually estimated and paid quarterly as a lack of payments usually results in penalties. As for NSOs, the issuing company withholds the tax amount for employees; this is because the minimum NSO exercise withholding requirement is merely twenty-two percent (22%) for up to a million ($1,000,000) spread value and thirty-seven percent (37%) for spread value that is over one million.
Since NSOs can be issued to nonemployees as well, the issuing company does not withhold taxes for nonemployees. Instead, all nonemployee holders of NSOs are expected to also handle their tax payments through the estimated quarterly payments just like ISO holders. This is often referred to as 1099.
Time of tax payment
When it comes to the payment of taxes, the potential Alternative Minimum Tax (AMT) that ISO holders might have to pay must not necessarily be filed immediately. The holders of ISO can also file an Internal Revenue Service (IRS) section 83(i) election where their taxes can be deferred for up to five (5) years. For NSOs, tax is withheld at the point of the exercise and they cannot file an IRS section 83(i) election.
If an ISO holder sells after the tax year of the exercise and a minimum of one year after the exercise and at least two years after the ISO grant date, then they will be subject to Alternative Minimum Tax (AMT) for the year of the exercise and also be subject to long term capital gains tax.
The taxes are calculated based on the difference between the selling price and the exercise price irrespective of the AMT that has already been paid on the difference between the exercise price and the fair market value at the time of exercising the stock option. When this occurs, it means the ISO holder has paid double taxes on the ISOs they own. The case of double taxation rarely occurs with NSOs
Exercising ISO or NSO
Exercising ISO or NSO is the process of actually purchasing the shares associated with the stock option you have been granted. The exercising of incentive stock options or nonqualified stock options can be done either early before the shares fully vest or after the vesting period.
For early exercising, issuing companies allow the employee to exercise their stock options immediately when it is granted, although it will still have to follow the stated vesting schedule. If the employee chooses to exercise the options after the vesting period, then they will be able to get all their shares at once. An additional option is being able to exercise the stock option as long as you remain an employee of the company.
For ISOs, all the aforementioned exercising options are available to their holders. Additionally, only one hundred thousand dollars ($100,000) worth of incentive stock options can be exercised yearly; this amount is calculated by multiplying the number of shares to be exercised by the strike price. If the ISOs value is above the limit, any excess will be treated as NSOs.
The exercise price of ISOs for employees who have up to ten percent (10%) in the issuing company is at least one hundred and ten percent (110%) of its fair market value (FMV). Most NSOs on the other hand can be exercised before their expiration date as specified in the option agreement. Furthermore, the exercise price for holders of NSO who have up to ten percent (10%) in the issuing company is at least its fair market value (FMV)
Related: Exercising stock options
Transferring ISO or NSO
Shares such as voting shares of companies could be easily transferred from the owner to another person but in the case of ISO vs NSO, it is different. ISOs are usually not transferable from the employee to any other person; the only exception is in a situation of the death of the employee. Conversely, NSOs are transferable; this is however based on certain conditions which are usually outlined in the stock option agreement.
Eligible recipients for ISO vs NSO
ISOs and NSOs also vary in the individuals to whom they can be granted. Incentive stock options can only be granted to a company’s employees whereas nonqualified stock options can be granted to employees, board members, contractors, consultants, service providers, and other stakeholders.
Termination of employment or service
In an instance when an individual or service provider no longer works for or with the company that issues the ISO or NSO they own, they have a limited time in which they can exercise their stock options. The period is known as the post-termination exercise period (PTEP). For Nonqualified stock options, the timing is quite flexible as they can be exercised at any time before their expiration date.
Incentive stock options on the other hand must be exercised within three (3) months after the termination unless its owner dies or becomes disabled in which case, the time might be extended. Additionally, some ISOs become automatically forfeited once there is a termination of appointment.
For the purpose of federal income tax, there are specified holding periods for both ISOs and NSOs if their owners are to obtain a long-term capital gain rate on their income tax. ISOs have to be held for the minimum holding period; additionally, they have to be held for up to a year from the date on which the incentive stock option was exercised and for two (2) years from the date on which it was granted.
The disqualifying disposition of the ISOs comes into effect by selling during the identical tax year as the exercise which will trigger ordinary income tax for the ISO. When this happens, the ISO holder is required to service it by quarterly income tax payments. NSOs have to be held for more than a year from the date on which the nonqualified stock option was exercised. If the owner of the ISO or NSO fails to hold the shares for the specified period, they are said to have a disqualifying disposition meaning that they are no longer eligible for the long-term capital gain taxes.
Expiration of ISO vs NSO
Most corporations that issue ISOs put an expiration date of not more than ten (10) years from the date on which it was granted. However, if the employee to whom the incentive stock option was issued is a company shareholder that owns up to a ten percent (10%) stake in the corporation, their ISOs will have an expiration date of not more than five (5) years. For non-qualified stock options, the expiration date varies as they are usually set in the NSO agreement plan.
Restrictions on ISO and NSO
The Internal Revenue Code (IRC) sections that regulate ISOs and NSOs differ remarkably. ISOs are regulated by section 422 of the IRC whereas NSOs are regulated by section 409a of the IRC.
In the US, incentive stock options can only be granted by any entity that is taxed as a corporation when it comes to payment of federal taxes whereas nonqualified stock options can be granted by partnerships, limited liability companies (LLC) as well as any entity taxed as a corporation (corporations).
A summary of ISO vs NSO differences
|Tax at Exercise||Generally not taxed but could be taxed at the Alternative Minimum Tax (AMT) rate if the spread between its fair market value and exercise price is above $73,600 for individuals and $114,600 for married persons filing jointly||The spread between its fair market value and exercise price is taxed at the ordinary income tax rate|
|Tax at sale||Taxed as capital gain if all the requirements are met||Usually taxed as ordinary income|
|Expiration||Expires after 10 years if not exercised. For those with up to ten percent of shares in the company, it expires after 5 years.||Expiration varies based on the agreement plan|
|Termination of appointment||Must be exercised within 3 months unless in a case of death or disability||Can be exercised any time before its expiry date.|
|Recipients||Only employees of the granting entity||Employees, advisers, contractors, consultants, and all other stakeholders of the granting entity.|
|Granting entity||Only corporations||Partnerships, Limited Liability Companies (LLCs), and corporations.|
|Disqualifying dispositions||Disqualified for long-term capital gains tax if not held for up to a year from the exercise date and up to two years after it was granted.||Disqualified for long-term capital gains tax if not held for more than a year from the exercise date|
|Regulated by||Section 422 of the Internal Revenue Code||Section 409a of the Internal Revenue Code|
|Tax deduction||The company that issues ISOs does not get a tax deduction||The company that issues NSOs gets a tax deduction which is equal to the amount of ordinary income recognized by the holder of the NSO when it was exercised|
|Yearly exercise limit||Only $100,000 worth can be exercised yearly||There is no limit to the amount that can be exercised yearly|
|Exercise price||For employees who are shareholders with up to 10% stake in the issuing company, it is at least 110% of its fair market value||For those who are shareholders with up to 10% stake in the issuing company, it is the fair market value|
|Transferability||Non-transferable except at the death of the employee||Can be transferred based on the conditions of the agreement.|
|Payroll taxes||Not applicable||Applicable|
ISO vs NSO similarities
- Both ISOs and NSOs have no tax event when they are granted or vest.
- They can both be used as incentives for employees
- Generally, both ISOs and NSOs have a vesting schedule that is time-based
- They can both enjoy capital gains tax rates if their minimum holding period is met by the holder.
See also: Employee stock options
We have learned about ISO vs NSO differences in terms of their taxation, transferability, and eligibility. They also differ in their expiration time frame and their grant price for shareholders with over 10% in the issuing company. Although both can be used as incentives to employees, they present different benefits and drawbacks to both the issuing companies and their holders. It is therefore important to consider these when deciding on either ISO or NSO.