Because of this favorable tax treatment, the availability of ISOs is limited. NQOs do not provide special tax treatment to the recipient. NQOs may be granted to employees, directors and consultants, while ISOs may only be granted to employees and not to consultants or non-employee directors.
Generally, there is no tax effect to the optionee at the time of grant or vesting of either type of option. Regardless of whether an option is an ISO or an NQO, it is very important that an option’s exercise price be set at not less than 100% of the fair market value (110% in the case of an ISO to a 10% stockholder) of the underlying stock on the date of the grant in order to avoid negative tax consequences.
Upon exercise of an ISO, the optionee will not recognize any income, and if certain statutory holding periods are met, the optionee will receive long-term capital gains treatment upon the sale of the stock. However, upon exercise, the optionee may be subject to the alternative minimum tax on the “spread” (i.e., the difference between the fair market value of the stock at the time of exercise and the exercise price of the option). If the optionee sells the shares prior to meeting such statutory holding periods, a “disqualifying disposition” occurs and the optionee will have ordinary income at the time of sale equal to the “spread” at the time of exercise plus capital gain or loss equal to the difference between the sale price and the value at exercise. If the shares are sold at a loss, only the amount of the sale in excess of the exercise price is included in the optionee’s income. The Company will generally have a compensation deduction upon the sale of the underlying stock equal to the amount of ordinary income (if any) recognized by the optionee if the holding period described above is not met, but the Company will have no compensation deduction if the ISO holding period is met.
At the time of exercise of an NQO, the optionee will have compensation income, subject to tax withholding, equal to the option's "spread" and taxable at ordinary income rates. When the stock is sold, the optionee will receive capital gain or loss treatment based on any change in the stock price since exercise. The Company will generally have a compensation deduction at option exercise equal to the amount of ordinary income recognized by the optionee.
These awards, which are essentially a hybrid of stock options and restricted stock, permit the grantee to exercise unvested options to purchase shares of restricted stock subject to the same vesting and forfeiture restrictions.
Restricted stock is stock sold (or granted) that is subject to vesting and is forfeited if the vesting is not satisfied. Restricted stock may be granted to employees, directors or consultants. Except for payment of par value (a requirement of most state corporate laws), the company may grant the stock outright or require a purchase price at or less than fair market value. In order for the risk of forfeiture imposed on the stock to lapse, the recipient is required to fulfill vesting conditions that may be based on continuing employment over a period of years and/or achievement of pre-established performance goals. During the vesting period, the stock is considered outstanding, and the recipient can receive dividends and exercise voting rights.
A recipient of restricted stock is taxed at ordinary income tax rates, subject to tax withholding, on the value of the stock (less any amounts paid for the stock) at the time of vesting. Alternatively, the recipient may make a tax code section 83(b) election with the IRS within 30 days of grant to include the entire value of the restricted stock (less any purchase price paid) at the time of grant and immediately begin the capital gains holding period.