Incentive Stock Options v. Non-Qualified Stock Options
November 7, 2018 | By Nic O'Brien
For cash-starved startups, compensating employees with options can be a great way for founders to motivate the employees to increase the company’s worth, and to remain with the company. However, the differing vehicles to issue options can be confusing. Often, this confusion centers around the difference between Incentive Stock Options or Non-Qualified Stock Options (also called Non-Statutory Stock Options).
At their core, Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs) are similar. With some exceptions, both are options to purchase a company’s stock at a predetermined exercise price after a certain period of time or after the achievement of milestones. But, the IRS treats ISOs and NQSOs differently. Theoretically, ISOs receive favorable tax treatment and additional restrictions to offset their benefit, while NQSOs receive double taxation.
Anyone – including employees, advisors, or other service providers – may receive NQSOs. NQSOs may vest over time or immediately, and may contain certain restrictions. But the main difference between ISOs and NQSOs is tax treatment. Again, NQSOs receive double taxation: NQSOs are taxed upon the options’ exercise and when the underlying shares are sold. Income from the NQSOs’ exercise receives ordinary income treatment and the income is subject to employment tax withholding. But if held for a year from the date of exercise, the income from the NQSOs’ sale may receive long-term capital gains treatment. And if held for less than a year, the income may receive short-term capital gains treatment, which may be taxed as ordinary income.
Alternatively, only employees may receive ISOs, and ISOs may contain vesting or other restrictions similar to NQSOs. But ISOs are only taxed when sold rather than exercised. Assuming the Alternative Minimum Tax does not apply, income from sales of ISOs may receive long-term capital gains treatment if the shares are held longer than one year from when the ISOs are exercised and two years from the ISOs’ grant date. The long-term capital gains rate is typically lower than the option recipients’ average ordinary-income tax rate, and thus, ISO recipients theoretically receive the tax benefit of paying taxes once at a lower rate.
Practically, however, ISO recipients often fail to fully reap the ISOs’ tax benefits. Because ISOs are exercised and simultaneously sold in conjunction with liquidity events, the option holders’ income from the sale of the ISOs is characterized as a short-term capital gain. Consequently, the income usually receives ordinary-income tax rates, eliminating the benefit of the lower long-term capital gains rate.
In addition to the potential loss of tax benefits, ISO issuances face additional restrictions. For example, ISO issuances to employees that own more than 10% of the voting power in the company are restricted much more than NQSOs. These employees must receive ISOs with an exercise price of 110% or more of the fair market value of the shares at the time the shares are granted. And, dissimilar from NQSOs and typical ISOs which may receive a ten-year period to exercise the options, ISOs issued to employees with more than 10% of the company’s voting power must receive a five-year period to exercise the options. Faced with the ISOs expiration, the five-year expiration period may force employees planning to hold the options until a liquidity event to undergo a large cash outlay in Year Five, which is avoided with longer expiration periods applicable to NQSOs.
Furthermore, when ISOs are issued to employees owning more than 10% of the voting power with an exercise price lower than 110% of fair market value or with expiration dates longer than five years from the ISOs’ grant date, the options become NQSOs rather than ISOs.
Additionally, the ISOs’ total aggregate fair market value (determined as of the grant date) that becomes exercisable within a calendar year may not exceed $100,000. The shares that cause the aggregate fair market value to exceed $100,000 do not qualify as ISO shares and become NQSOs. The shares valued at $100,000 or less remain ISOs. For example, if an employee receives immediately exercisable ISOs to acquire the company’s stock with an aggregate fair market value of $150,000 on the grant date, the first $100,000 in options remain ISOs, and the remaining $50,000 in options become NQSOs. For most startups, this limitation will not factor into the company’s decision making, but once a company has raised a Series B round or later, option recipients may confront this limit.
In conclusion, NQSOs’ ease of issuance may prove more attractive than the restrictions placed on ISOs. But ISOs’ beneficial tax treatment when exercised and held may outweigh the lack of restrictions on NQSOs’ issuances. Ultimately, founders must survey their company’s horizon and determine which option form is best for their employees.