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ISO vs NSO: Employee Stock Options and Their Tax Implications

By John DiGiacomo

It is common for businesses — particularly startups — to try and incentivize their employees (and other agents like directors and third-party vendors) with stock options. Very broadly speaking, stock options can be divided into two categories — incentive stock options (“ISO”) and non-qualified stock options (“NSO”). By definition, an ISO is a stock option plan that qualifies for special tax treatment under the US tax code; all other stock option plans will be NSOs — that is, an NSO is a stock option plan that does not satisfy the IRS definition of an ISO. There are many reasons to create NSOs instead of ISOs and, for various reasons, what was originally meant to be an ISO can be converted — purposely or by passage of time and events or by operation of law — into an NSO. For example, one IRS requirement for an ISO is that it be offered only to employees. If, however, the employee becomes a director of the company or an outside consultant while the stock option is vesting or while the hold-before-selling period is running, then the ISO fails to meet the IRS definition. The stock option plan is still valid; but it has become an NSO with resulting tax consequences.

What are the Tax Implications of an ISO vs. an NSO?

Satisfying the IRS definition for an ISO can be beneficial for an employee with respect to federal taxation of $100,000 in income. First, the gain in value of stock is taxed at different rates. If the ISO requirements are met, then income from the gain in value of stock is taxed at the long term capital gains rate — 15 to 20% under current law. By contrast, stock value gains — at the point of option exercise — for an NGO are taxed as regular income — often 30% or higher — and are subject to potential payment of social security and medicare payroll taxes which can add another 6% or so to a person’s individual tax obligation.

Further, taxes are assessed at different times for an ISO vs. an NSO. With an ISO, the “taxable event” occurs when the taxpayer SELLS the stock granted through the option. This can be very important since taxes are due only AFTER a sale, which means that a taxpayer actually has cash or liquid funds on hand to meet their tax obligations. As noted, all value gain for the stock is taxed as capital gains.

By contract, there are two “taxable events” for an NSO. The first occurs when the taxpayer EXERCISES the stock option. What is taxed is the difference between the fair market value (“FMV”) of the stock and the option price. For example, if the stock has a FMV of $1.00 and the option price is $0.50, then the taxpayer is taxed on 50 cents of “income” for each share of stock purchased. As noted, this “income” is taxed as regular income, not as long term capital gains income. This can be very problematic for a taxpayer who may not have cash or liquid funds on hand to meet the resulting tax obligations. Even worse problems arise when a taxpayer thinks that the grant is exercised under an ISO, but it is later determined that the ISO did not meet the qualifications. If that happens, then significant taxes may have been due in previous tax years necessitating the filing of amended tax returns and the payment of interest and penalties. The second “taxable event” occurs when the stock granted is sold. At that point, the taxpayer is assessed taxes on the difference between the FMV at the time of exercise and the sales price at the time of sale. This is taxed at the rate for long term capital gains.

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