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). |
What is Section 409A?
January 19, 2008
Background
On April 10, 2007, the Internal Revenue Service (IRS) issued final regulations under Section 409A of the Internal Revenue Code. Section 409A was added to the Internal Revenue Code in October 2004 by the American Jobs Creation Act.
Under Section 409A, unless certain requirements are satisfied, amounts deferred under a nonqualified deferred compensation plan (as defined in the regulations) currently are includible in gross income unless such amounts are subject to a substantial risk of forfeiture. In addition, such deferred amounts are subject to an additional 20 percent federal income tax, interest, and penalties. Certain states also have adopted similar tax provisions. (For example, California imposes an additional 20 percent state tax, interest, and penalties.)
Implications for discount stock options
Under Section 409A, a stock option having an exercise price less than the fair market value of the common stock determined as of the option grant date constitutes a deferred compensation arrangement. This typically will result in adverse tax consequences for the option recipient and a tax withholding responsibility for the company. The tax consequences include taxation at the time of option vesting rather than the date of exercise or sale of the common stock, a 20% additional federal tax on the optionee in addition to regular income and employment taxes, potential state taxes (such as the California 20% tax) and a potential interest charge. The company is required to withhold applicable income and employment taxes at the time of option vesting, and possibly additional amounts as the underlying stock value increases over time.
I will write a future post on “How do you set the exercise price of stock options?”
Additional information
Below are links to all of WSGR’s client alerts on 409A.
You can assess the applicability of Section 409A by reviewing WSGR’s client alerts covering various aspects of Section 409A and the final Section 409A regulations in detail, including highlights, stock rights, separation pay arrangements, traditional deferred compensation arrangements, action items for compliance and transition relief.
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