What’s the difference between an ISO and an NSO?

March 5, 2008

[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).

Comments

  • http://www.mystockoptions.com Bruce Brumberg, Editor, www.myStockOptions.com

    Useful chart. and quick summary. One addition for ISO taxes: When ISO exercise triggers AMT, tax credit available for use in future tax years, and when the ISO stock is sold, another very complex AMT adjustment. You might want to see the ISO or NQSO sections on http://www.myStockOptions.com, particularly for annotated examples of Schedule D for tax return reporting.

  • newfounder

    Hi Yokum
    We need to issue equity warrants in lieu of cash for both contractors, landlords, and employees of our startup. We are pre-series A financing so would like to issue $ based warrants to be converted at the series A share price. However, we also would like to minimize the personal income tax liability to the individuals as it is really the intention of the warrant to pay them in stock which they would only owe captial gains tax on sometime in the future.

    My question is: Should these warrants be structured as stock grants or stock options to be converted to common stock at series A funding? If grants, wouldn’t the individual be liable for the full value of stock at income tax rate at series A converstion? if options, should strike price simply be at par value as there is no real FMV of stock?

    Please help clarify the typical equity warrant issued pre-series A financing in lieu of cash.

    Thanks

  • http://www.startupcompanylawyer.com Yokum

    @newfounder,

    1. Typically, most companies would issue an option to purchase common stock to these people at a low exercise price equal to fair market value. I generally don’t recommend an exercise price of less than $0.02/share, as the IRS would likely take the position that the stock was simply granted to the person because the exercise price was too low, resulting in immediate tax on the value of the underlying stock. Keep in mind that a stock grant (i.e. recipient gets the stock for free) result in tax to the recipient on the value of the stock.

    2. Options may be fully-vested in the case of landlord, or subject to a vesting schedule in the case of service providers.

    3. Options and warrants mechanically work the same way in that they are a right to purchase stock in the future. They are called options when they are compensatory.

    4. A warrant to purchase yet to be issued Series A stock at the Series A price is somewhat odd, unless bundled in connection with a convertible note or as a kicker on debt. The number of shares to be issued would be $X/Series A price. At the time this warrant is issued, the value of the warrant strikes me as income.

    5. What it seems like you are trying to do is promise to issue Series A stock worth $X at the time of the Series A. This would result in the taxable income of $X to the recipient at the time the Series A is issued. If the person is an employee, it seems like there are also some 409A issues because this may be deemed deferred compensation.

  • Sam

    Hi Yokum,

    I am starting a company that today is nothing more than an idea. I have taken no funding and have no product (or revenue) yet. I incorporated a Delaware company one month ago with shares that have a par value of $0.001 each. I issued myself 1,000,000 shares for $1,000. I will likely raise a small round of angel funding once I have a proof of concept. I now have the agreement of someone to help me in an advisory capacity create that proof of concept and I will grant him an NSO as compensation. I understand the NSO must be “fair market value” but given that the company has no value today should the exercise price be the par value (i.e. $0.001) or something higher?

    Thanks

  • http://www.startupcompanylawyer.com Yokum

    @Sam – I would set the exercise price at something like $0.02/share or higher. See rationale in comment above.

  • McGregory

    Hey Yokum – this is a great post!

    Please consider the following scenario:

    the us-based ‘start-up’ is 6 years old and an employee (no US citizen / on an H1-B work visa) has been working for the company for almost 4 years. he was one of the early employees and received quite a chunk of SARS for a low strike price. The company is private and an s-corp (foreign ownership is not possible) so the SARS are not vesting into options. what will now happen upon termination of the employment contract? can the employee excercise his vested SARS for cash at the current fair market value strike price of the company OR will he lose all SARS? If he cannot excercise, will the company keep the SARS until a liquidity event occurs? Does he have to follow the regular exercise schedule? What happens if the company converts into a C-corp in the next future? Will his SARS automatically convert to options?

  • http://www.startupcompanylawyer.com Yokum

    @McGregory – I assume that you are talking about stock appreciation rights, as opposed the virus. Virtually no silicon valley venture-backed startups use SARs instead of stock options, so it is difficult to speak in generalities as to how SARs work. Basically, you have to read the SAR document carefully.

  • LJ

    We have a non qualified stock option plan for an LLC. Vesting and exercise was to occur at a liquidation event such as an acquisition or sale, which we thought might occur within a year, to alleviate the possibility of low level employees vesting and exercising options and becoming a member of the LLC and accompanying tax issues – K-1's etc. As our time horizon is growing, we wanted to include a 3 year vesting period. Question is, upon vesting, would our employees face a taxable event. We did have a valuation done, and the exericise price was set above the value at grant date to avoid any 409a issues.

  • http://www.startupcompanylawyer.com Yokum

    @LJ – There is no such thing as a “standard” option plan for an LLC, so it's hard to generalize without seeing the actual documents as it depends on what kind of LLC interest was granted. Please ask your own lawyers who set up the option plan and the operating agreement.

  • Ken

    I'm not quite clear on that response. You seem to be saying that warrants would never be used to compensate contractors, but rather NSOs?

    As a contractor considering receiving a percentage of my compensation as equity, I'm confused about the idea of receiving options in lieu of cash. It seems to me that I should be granted stock in exchange for cash I don't receive, not the option to buy stock. I understand that an option to buy later at today's price has some value, but that value is not necessarily related to the current price. In other words, if I'm owed $100, then 100 options to buy stock at $1.00 isn't necessarily a fair alternative to $100 cash. The stock value would have to double before I could hand over $100 in order to get $200 back, netting $100.

    It seems like the original poster above was indeed trying to figure out how to compensate contractors with stock. In your response section 5, are you suggesting a stock grant? And that couldn't be done until the Series A, and would be treated as taxable income?

  • Ken

    I think I've learned enough now to answer my own question: Assuming that the FMV of the stock isn't measured in pennies, then options aren't well suited for direct compensation (although they still work fine as a “bonus” for employees). The stock would have to double in value to provide the intended compensation. Stock grants are no good, either, because they will have large tax consequences. The solution is to issue warrants priced at $0.01 per share, which can be done legally regardless of the current FMV of the stock. Of course, thanks to the ridiculous IRS position of them wanting taxes before the stock is actually sold (!!), it normally won't make sense to exercise the warrants until you can sell at least some of them to cover the tax bill (just like options, except possibly ISOs with their special tax treatment).

  • raghavan1

    Hi Yokum,
    This is a great forum with full of useful info. We're forming a C type company. A person who has been contributing since the pre-incorporation days wants to invest in the equity just like other co-founders and then be a consultant. He is not an accredited investor. We need him but he doesn't want to be an employee or board member. Is it possible for the company to go with him? Will the stocks given to him all be NSO? Thank you very much – Raghavan

  • http://www.startupcompanylawyer.com Yokum

    @Raghavan – I would just issue and sell common stock to him at the same price as other founders. Please keep in mind that if he has a day job, there may be limitations on his ability to purchase stock.

  • raghavan1

    Thanks, Yokum! Is there any way you could expand on your comment 'if he has a day job, there may be limitations on his ability to purchase stock'? Can NSO be assigned to a non-employee who may be an advisor to the start up but may have a full time job elsewhere? Thanks again. Raghavan

  • http://www.startupcompanylawyer.com Yokum

    @Raghavan – see this post http://www.startupcompanylawyer.com/2009/01/08/

  • raghavan1

    Thanks, Yokum! Is there any way you could expand on your comment 'if he has a day job, there may be limitations on his ability to purchase stock'? Can NSO be assigned to a non-employee who may be an advisor to the start up but may have a full time job elsewhere? Thanks again. Raghavan

  • http://www.startupcompanylawyer.com Yokum

    @Raghavan – see this post http://www.startupcompanylawyer.com/2009/01/08/

  • Rahul Berman

    Hi Yokum – is there any scenario in which a company can extend the 90-day exercise period for ISOs for a departing employee? Can the nature of the relationship with the employee be changed to an advisor and thereby not trigger the exercise period? Are there other ways of structuring/changing the relationship, assuming the company was willing to go that route?

  • http://www.startupcompanylawyer.com Yokum

    @Rahul – Typically, an option agreement has language that says that the option must be exercised within X days (i.e. 90 days) of termination of status as a service provider. Service provider is broad enough to encompass employees, directors, consultants, advisors, etc. Thus, an employee can move to contractor status and the option typically continues to vest and does not need to be exercised. in addition, the 90 day period can be extended. However, the ISO will turn into an NSO if the employee is no longer an employee after 90 days.