[The following is not intended to be comprehensive answer. Please consult your own tax advisors and don’t expect me to answer specific questions in the comments.]
Incentive stock options (“ISOs”) can only be granted to employees. Non-qualified stock options (“NSOs”) can be granted to anyone, including employees, consultants and directors.
No regular federal income tax is recognized upon exercise of an ISO, while ordinary income is recognized upon exercise of an NSO based on the excess, if any, of the fair market value of the shares on the date of exercise over the exercise price. NSO exercises by employees are subject to tax withholding. However, alternative minimum tax may apply to the exercise of an ISO.
If shares acquired upon exercise of an ISO are held for more than one year after the date of exercise of the ISO and more than two years after the date of grant of the ISO, any gain or loss on sale or other disposition will be long-term capital gain or loss. An earlier sale or other disposition (a “disqualifying disposition”) will disqualify the ISO and cause it to be treated as an NSO, which will result in ordinary income tax on the excess, if any, of the lesser of (1) the fair market value of the shares on the date of exercise, or (2) the proceeds from the sale or other disposition, over the purchase price.
A company may generally take a deduction for the compensation deemed paid upon exercise of an NSO. Similarly, to the extent that the employee realizes ordinary income in connection with a disqualifying disposition of shares received upon exercise of an ISO, the company may take a corresponding deduction for compensation deemed paid. If an optionee holds an ISO for the full statutory holding period, the company will not then be entitled to any tax deduction.
Below is a table summarizing the principal differences between an ISO and an NSO.
| ISO | NSO | |
| Tax Qualification Requirements: | * The option price must at least equal the fair market value of the stock at the time of grant.
* The option cannot be transferable, except at death. * There is a $100,000 limit on the aggregate fair market value (determined at the time the option is granted) of stock which may be acquired by any employee during any calendar year (any amount exceeding the limit is treated as a NSO). * All options must be granted within 10 years of plan adoption or approval of the plan, whichever is earlier. * The options must be exercised within 10 years of grant. * The options must be exercised within three months of termination of employment (extended to one year for disability, with no time limit in the case of death). |
None, but an NSO granted with an option price less than the fair market value of the stock at the time of grant will be subject to taxation on vesting and penalty taxes under Section 409A. |
| Who Can Receive: | Employees only | Anyone |
| How Taxed for Employee: | * There is no taxable income to the employee at the time of grant or timely exercise.
* However, the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the alternative minimum tax. * Gain or loss when the stock is later sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i.e., the amount paid on exercise). * Disqualifying disposition destroys favorable tax treatment. |
* The difference between the value of the stock at exercise and the exercise price is ordinary income.
* The income recognized on exercise is subject to income tax withholding and to employment taxes. * When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise). |