Now, we’re going to focus on the differences between the two most common types of options – ISOs and NSOs – and discuss how they could impact your choices to exercise your options and eventually sell your shares.
ISO stands for incentive stock option. ISOs can only be granted to employees and can’t be transferred to family members or friends. Arguably, the best thing about ISOs is that they are not subject to income tax upon exercise. Additionally, ISO holders benefit from not being subject to Social Security or Medicare taxes on these options. There are other tax benefits upon disposition as well, as long as you follow certain IRS rules.
NSO, also known as NQSO, stands for non-qualified stock option. NSOs can be offered to employees, as well as to contractors, consultants, and directors. NSOs are taxed as ordinary income and are subject to Social Security and Medicare Taxes. Tax withholding is due at the time of exercise, and additional quarterly estimated tax payments may be necessary if withholding is insufficient.
What Are the Differences Between ISOs and NSOs?
ISOs and NSOs are two types of stock options that can be offered to company employees, allowing them to purchase a specified number of shares at a predetermined price and participate in the company’s potential future success.
However, different rules and regulations apply to ISOs and NSOs – read on to learn about the key differences between them.
ISOs can only be granted to company employees, and many private companies (and around 80% of private companies in Silicon Valley) choose to grant ISOs to their employees. In contrast, NSOs, the less popular form of equity compensation, can also be granted to other service providers, such as contractors, consultants, and non-employee directors.
ISOs cannot be transferred by the employee to third parties, including family members or friends (except upon death). NSOs, on the other hand, can be transferred to others under certain conditions, as set by the employee’s stock option agreement.
PTEP – Post Termination Exercise Period
As covered in the Employee Stock Options – The Beginner’s Guide Part 1, employees usually have a limited time period (known as the post-termination exercise period or PTEP) to exercise their options once they leave the company. In most cases, ISOs must be exercised within 90 days after the termination date, while the time frame for exercising NSOs is more flexible and set by the employee’s stock option agreement.
Perhaps the most important difference between ISOs and NSOs lies in the way that they are treated by the IRS:
NSOs are taxable upon exercise. These options will be subject to ordinary income tax rates and to Social Security and Medicare taxes at that time.
ISOs are also not taxable at the time of exercise unless they trigger an Alternative Minimum Tax (AMT), which is due at the next quarterly estimated tax due date.
To qualify for this preferential tax treatment, ISOs need to meet the previous requirements (regarding eligibility, transferability, and the PTEP), as well as the following conditions:
ISOs must be exercised within ten years of the grant date.
ISOs must be held for more than two years after the grant date, and the shares obtained from exercising ISOs must be held for at least one year.
Employees can be granted up to $100,000 worth of ISOs each calendar year, based on the fair market value at the grant date (any excess will be treated as NSOs).
The exercise price for ISO must not be less than the stock’s fair market value at the grant date.
For significant shareholders (> 10% shareholders), the exercise price must be at least 110% of the fair market value, and the ISOs must be exercised within five years after the grant date.
ISOs can only be granted by an entity that is taxed as a corporation.
In the next section of this guide, we dive into how these differences play out during the different stages of the options’ life cycle.
What Taxes Are Associated With Each Type of Stock Option?
Neither ISOs nor NSOs are taxed at the time of option grant.
ISOs are also not taxable at the time of exercise unless the transaction triggers the Alternative Minimum Tax (AMT) (which will be discussed in a future post). In contrast, the difference between the exercise price and the fair market value of NSOs is treated as ordinary income at the time of exercise, and taxes are due at that time.
When the shares are ultimately sold, the difference between the sale and exercise prices is treated as capital gains (or loss) for ISOs. For NSOs, however, the capital gains tax is applied to the difference between the sale price and the fair market value at exercise.
Let’s continue our example from Part 1 of the guide:
You’re an employee at FuzzyBear Inc. You’ve been awarded 8,000 stock options, with an exercise price of $0.50 and a four-year vesting period. Here’s a step-by-step outline of what you’d typically have to pay:
Taxes on ISOs
You are granted 8,000 ISOs in January 2017. You don’t have to pay any tax.
In January 2019, you decided to exercise 4,000 ISOs that have vested to date – the current market value is $4 per share, but you buy the shares at the exercise price of $0.50 each.
Congratulations! You now own shares worth $16,000, and you haven’t been charged any tax (unless you are liable for AMT).
If you sell your shares at $4.50 in 2019 (less than a year after exercising), you’ll be charged ordinary income tax on the difference (or “spread”) between the sale price and the exercise price ($4.50 – $0.50 = $4 x 4,000 shares = $16,000). This is called a disqualifying disposition, as your ISOs have not met the condition of a 1-year holding period.
If you sell your shares at least a year after exercising (and at least two years from the grant date), you should report the sale on your tax reports as long-term capital gains tax on the profit you’ve made.
Taxes on NSOs
You are granted 8,000 NSOs in January 2017. You pay zero tax.
In January 2019, you decided to exercise 4,000 NSOs – the current market value is $4, but you buy the shares at the exercise price of $0.50 each.
Congratulations! You now own shares worth $16,000, and you only spent $2,000. You have earned $14,000 in taxable compensation, and the IRS charges the income at your ordinary income tax rate on the spread between these prices. For example, for a 22% income tax rate, you’ll pay $3,080 at the time of exercise, in addition to Social Security and Medicare taxes.
If you sell your shares at $4.50 sometime in 2019 (less than a year after exercising), you’ll be charged short-term capital gains tax on the spread between the sale price and the fair market value on the exercise date ($4.50 – $4 = $0.5 x 4,000 shares = $2,000).
If you sell your shares at least a year after exercising, you’ll be charged long-term capital gains tax on the profit you’ve made.
*Note: There are ways to reduce the amount of tax payable on your ISOs or NSOs. In general, it’s usually best to hold your shares for at least 12 months to reduce your taxes. However, there can be reasons to sell early, such as the need to access urgent cash or if you expect a large drop in the stock’s value. We’ll cover this topic in an upcoming post, so stay tuned!
When Should You Exercise ISOs or NSOs?
Choosing a time to exercise your stock options is tricky, and falls anywhere between the time they vest and their expiration date. We will discuss this in detail in a future post, taking into account the different tax implications for ISOs and NSOs. In the meantime, here are a few questions you should ask yourself before choosing to exercise either type of option, based on what we’ve learned so far:
How urgently do you need to access cash, and what other options do you have for getting it?
How many of your options have vested?
When do your options expire?
How long can you hold on to your shares once you exercise your options?
What is your current income tax bracket, and is it likely to change in the near future?
What is the stock’s current fair market value?
Do you expect the stock’s value to rise or fall over the next few years?
What is your level of risk tolerance?
Next, you’ll need to carefully consider your financial situation and look into the possible tax implications for exercising your options, holding on to your shares, and selling them. Whether you have NSOs or ISOs, read the next installment of the Employee Stock Options Guide for more guidelines from EquityBee on how to fund your stock options and estimate your tax obligations.
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