Founders University: Incentive Stock Options vs. Non-qualified Stock Options

Welcome back to Founders University, our core curriculum designed to provide startup founders with the basics needed to launch a company while minimizing costly missteps or mistakes.

For our next session of Founders University, we share a comparison of Incentive Stock Options (ISOs) and Non-qualified – or Non-statutory – Stock Options (NSOs). In this course, partners John Egan and Lynda Galligan talk about some of the key definitions and common terminology that are used for stock options.

Ready. Set. Learn!

There are two basic types of stock options: ISOs and NSOs. The key differences between these two types are how they are taxed and the relevant requirements. Here is a quick summary of those key concepts.

ISOs

Rules

ISOs can only be granted to employees – either full-time or part-time. There are several other rules that must be followed to maintain ISO status, including that the option plan has to be approved by stock holders. ISOs must also be exercised within 90 days of termination of employment.

There are also dollar limits on the number of ISOs that can be exercisable by any one taxpayer in a calendar-year period. In addition, there are special rules that must be followed for ISO grants to 10% or more holders.

Taxation

At grant, there is no tax to the optionee. When the optionee exercises the option, there is no tax, but the spread at the time of exercise can be subject to the Alternative Minimum Tax (AMT).

After exercise and upon the sale of shares, if the holding period is met – which is the longer of two years from the option grant date and one year from exercise – then the spread is taxed at long-term capital gains rates.

Upon the sales of shares after exercise, if the holding period is not met, then the spread at exercise – or gain upon sale if less – is taxed at ordinary income tax rates.

NSOs

Rules

NSOs can be granted to employees and non-employees, including directors and consultants.

An option that attempts to be an ISO but fails for any reason is taxed as an NSO.

Taxation

Generally there is no tax on grants. Upon exercise, the spread is taxed at ordinary income tax rates and is subject to FICA and Medicare, and tax withholding is required for employees.

Upon the sale of shares after exercise, any appreciation over the value at exercise is taxed at capital gains rates – long-term or short-term, depending on the holding period.

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