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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For more information or if you need legal help with business matters, contact the business lawyers at Revision Legal at 231-714-0100.

ISO Qualification Requirements Under the Tax Code

To qualify as an ISO under Section 422 of the Internal Revenue Code, a stock option plan must meet a precise set of requirements. Failing any one of these converts the ISO into an NSO for tax purposes, with potentially significant financial consequences for the recipient:

• Employee-only grant — ISOs can only be granted to employees of the corporation or a parent or subsidiary corporation. Consultants, independent contractors, directors who are not employees, and other service providers cannot receive ISOs.
• Written plan approved by shareholders — The stock option plan must be in writing and must be approved by the corporation’s shareholders within 12 months before or after the plan is adopted.
• Exercise price at or above fair market value — The option exercise price must be at least equal to the fair market value of the underlying stock on the date the option is granted. For 10% shareholders, the exercise price must be at least 110% of fair market value.
• $100,000 annual limit — The aggregate fair market value of stock underlying ISOs that first become exercisable in any calendar year cannot exceed $100,000. Options exceeding this amount are treated as NSOs to the extent of the excess.
• Holding period requirements — To receive long-term capital gains treatment on an ISO, the recipient must hold the stock for at least two years from the grant date and at least one year from the exercise date. If either holding period is violated, the disposition is a “disqualifying disposition” and ordinary income recognition results.
• 10-year term limit — An ISO must be exercised within 10 years from the grant date (five years for 10% shareholders).

Alternative Minimum Tax and ISOs

One significant risk of ISOs that is frequently overlooked is the alternative minimum tax (“AMT”). When an employee exercises an ISO and holds the stock (rather than selling it immediately), the spread between the exercise price and the fair market value at exercise is an AMT preference item. If the recipient’s AMT liability exceeds their regular tax liability in the year of exercise, they owe the difference as AMT.

This AMT exposure can be devastating if the stock declines in value after exercise but before sale. The employee owes AMT based on the value at exercise but may receive less than that amount — or nothing — when the stock is eventually sold. This scenario played out for thousands of employees of technology companies during the dot-com crash. Careful tax planning — including partial exercises, same-day sales in some years, and AMT modeling — is essential for employees holding ISOs in appreciating stock.

Why Startups Often Prefer ISOs Over NSOs for Employees

From the company’s perspective, ISOs and NSOs have different tax treatments as well. When an employee exercises an NSO, the company receives a compensation deduction equal to the spread — the difference between the exercise price and fair market value. When an employee exercises an ISO, the company generally does not receive a compensation deduction (unless the employee makes a disqualifying disposition). For early-stage startups that are not yet profitable and cannot benefit from a deduction, this difference is often irrelevant. The more compelling reason startups favor ISOs for employees is the employee-favorable tax treatment, which makes ISOs a more attractive retention and incentive tool.

NSOs are often used for grants to consultants, advisors, board members, and others who do not qualify for ISOs, as well as for grants that exceed the $100,000 ISO annual limit. Many mature companies use a combination of ISOs and NSOs in their equity compensation programs.

Key Drafting Considerations for Stock Option Plans

A well-drafted stock option plan addresses not only tax qualification requirements but also the following business and legal considerations:

• Vesting schedules — Most plans use a four-year vesting schedule with a one-year cliff, meaning the recipient earns 25% of the options after one year of continuous service and the remainder vests monthly or quarterly over the subsequent three years. Vesting schedules should address acceleration triggers in the event of a merger, acquisition, or termination without cause.
• Post-termination exercise window — The plan should specify how long an employee has to exercise vested options after separation from the company. The standard is 90 days for voluntary resignation; options typically terminate on separation for cause. Some companies are extending post-termination exercise windows to 5 or 10 years to reduce the financial burden on departing employees.
• Section 409A compliance — Stock options granted at or above fair market value generally fall within a Section 409A exemption for stock rights. However, options granted below fair market value are treated as nonqualified deferred compensation subject to Section 409A’s strict requirements, with severe tax penalties for noncompliance.

Equity compensation is one of the most powerful tools available to growth-stage companies but one of the most legally complex to implement correctly. Contact the business lawyers at Revision Legal at 231-714-0100 for help drafting or reviewing your stock option plan.