Stock options are becoming more and more common, particularly among startups looking to recruit top personnel without going over their compensation budget. Companies add stock options to an employee’s remuneration package in place of a greater salary. This helps organizations recruit and retain top talent and provide financial advantages to employees. Incentive stock options (ISOs) and non-qualified stock options (NSOs) are the two basic stock options used for equity compensation. ISO taxation and NSO taxation vary, and understanding the distinction is crucial to your financial management. This article is for anyone looking to understand ISO vs NSO and determine which stock options suit their company’s needs. We will discuss the difference between ISO and NSO, stock options types, benefits of stock options, and stock options vesting schedule.
Stock Options: ISO vs NSO
Stock options can make employee remuneration packages incredibly alluring even when the company cannot compensate with significant salary figures. However, companies need to understand ISO vs NSO to determine which is best for their company and its employees. The difference between ISO taxation and NSO taxation is usually the case builder; however, it’s also essential to understand other aspects.
What are stock options?
Stock options are a sort of equity remuneration that businesses provide to their employees, consultants, executives, contractors, and investors. These arrangements, or options, provide employees with the right to purchase or exercise a certain predetermined number of company stock shares at a specified grant price. However, this deal is only for a specific period, and before the options expire, employees have to exercise them. An employee might need to exercise the options within a certain period after departing from the firm.
Depending on the business, different companies will provide other numbers of options to their employees. Additionally, it can rely on the employee’s experience and unique talents. Before any employee may get stock options, investors and other stakeholders must provide their approval.
How do stock options benefit an organization or business?
There are several benefits of compensating employees with stock options. Here are a few:
- In an economy that is becoming more globally linked and where there is fierce rivalry for top talent, it is a crucial tool for hiring the most talented individuals.
- It can increase employees’ financial security and work pleasure by offering generous financial incentives.
- Employees are encouraged to contribute to the company’s expansion and success since they will benefit from it.
- In some instances, owners may use it as a possible escape plan.
Types of stock options
Stock options may be divided into incentive stock options (ISOs) and non-qualified stock options (NSOs). Let’s examine them in depth to draw a case for ISO vs NSO.
- ISO – An incentive stock option (ISO) is a business perk that enables employees to purchase company shares at a discount with the potential for tax benefits on the gain. They are also known as statutory or qualified stock options. The tax rate applied to profits from eligible ISOs is typically the capital gains rate rather than the higher rate for regular income. Senior management and highly valued staff are the only ones that get ISO stock.
- NSO – Employee stock options that are non-qualified (NSOs) necessitate the payment of ordinary income tax on the discrepancy between the option’s exercise price and the grant price. Profits from these are treated as regular income and are taxed accordingly; they are sometimes referred to as non-statutory stock options. They could be given to almost all employees and the members of the board and consultants in the organization.
Differences between ISO and NSO
Understanding ISO vs NSO is fundamental to granting them correctly. Check out the table below to understand the important differences between the two.
|Who Can Grant?||Exclusively for corporations|
Includes any company subject to corporate taxation under US federal law.
|Corporations, Limited liability companies or LLCs, and partnerships.|
|Who gets it?||Only for employees||Service providers of the entity, such as advisors, consultants, employees, and directors.|
|Tax during exercise||Normally, no tax event|
Take note that to determine the Alternative Minimum Tax (AMT), the differential gap between the exercise price and FMV is recognized as income and might result in AMT taxes.
|Spread is subject to federal income taxation as ordinary income.|
|Tax at the time of Sale||Required to pay taxes as a long-term capital gain on sale price - exercise price.||Sale price - FMV upon exercise is taxable as a capital gain.|
|Deduction to the granting entity||No||When the grant is exercised, the grantee must record ordinary income, and the granting company is entitled to a tax deduction equivalent to that amount.|
|Holding Time to get a rate of Long-Term Capital Gain for the Purposes of Federal Income Tax||Hold for||Hold for
|How to Exercise after Termination||Within three months or longer after death or incapacity unless the plan specifies a shorter time frame.||Planned or agreed upon and not later than the option's expiry date.|
|Restrictions on value||For each employee, only $100,000 may be used in a single calendar year.||No limits|
|Transferable?||Upon death||As planned or agreed|
|For more than 10% of Stockholders||The option period must be five years or shorter, and the price of exercising must be at least 110% of FMV.||The option period must be specified by plan or agreement, and the exercise price must be at minimum FMV.|
|Expiry||10 years from the award date, or 5 years in the case of 10% shareholders, as mentioned above.||Determined by the plan/agreement.|
Granting ISO or NSO: Which is better?
Understanding the ISO vs NSO and the difference between ISO taxation and NSO taxation can help employers choose which ones to grant to their employees.
After the vesting period, you can exercise your options and acquire corporation shares. Options are worthless unless exercised. The contract you signed sets the pricing for these options – the exercise price, grant price, or strike price. This pricing won’t alter no matter how the firm performs.
Let’s imagine you have 10,000 $1 stock options after four years. You’d need $10,000 to exercise them all. After exercising, you can sell all the shares because you own them. You can also wait in the hopes that the share price rises. You must pay commissions, fees, and taxes when exercising and selling options.
Some methods of exercising that don’t need money. They are:
- Exercise-and-sell – To accomplish this, buy and sell options simultaneously. Instead of using your funds to exercise, the brokerage managing the transaction offers to pay the cash, using the sale’s proceeds to acquire the shares.
- Exercise-and-sell-to-cover – You sell sufficient shares to pay for the purchase and keep the remainder. It is necessary to know that your options can expire as per the contract. Options usually expire 10 years after being granted or 90 days after you depart.
When is the right time to exercise stock options?
If all signs indicate a rising stock price and you can afford to retain your shares for a year, exercise your options immediately. This reduces capital gains and income taxes. If your term to exercise is almost up, you may wish to lock in your lower pricing. If you fear losing money, seek an investing professional.
How and when to exercise stock options depends on several things:
- Wait till the firm becomes public – Your stock could be valued less than you bought for if your firm doesn’t go public.
- After IPO – Exercise when the stock price climbs above your exercise price.
Tax Implications of ISO and NSO
ISO taxation and NSO taxation have different implications for employees. Understanding the distinction is crucial to your financial planning.
How are ISOs taxed?
ISO taxation benefits are often greater than NSO taxation since workers with ISOs do not have to pay taxes immediately after exercising the options. Only when shares are sold, do ISO holders have to pay taxes. The gains are not considered ordinary income; they are capital gains if the employee holds the shares for a year or more after vesting or two years or more following the grant date. The ISO taxation, ordinary or capital gains, are not required until you submit your tax returns for the year they are sold.
The main danger with ISOs is that the stocks might depreciate before being able to be sold, particularly if you need to compensate for the alternative minimum tax (AMT) during the year you exercise. You lose the advantage of long-term capital gains tax that makes them so alluring in the first place if you dispose of them without waiting a year after vesting, which is disqualifying disposal.
Let’s imagine, for instance, that on January 1, 2020, you were given 100 ISOs and a vest on January 1, 2021. You will need to retain the shares for at minimum a year to be eligible for the advantageous capital gain tax treatment if you exercise and hold the options as of January 1, 2021.
How are NSOs taxed
NSO taxation is unique. The spread, or the disparity between the exercise price and grant price, is considered earned income and is subject to ordinary income tax irrespective of whether you keep your stock options or dispose of them. Taxes are deducted from NSO taxation at the time of exercise.
Payroll taxes on this earned income, including Social Security and Medicare, are also applicable. On profits up to $137,700, social security payroll taxes are equivalent to 6.2%. You will be required to pay only the 1.45% Medicare tax if your net profit exceeds this. However, your profits will be subjected to your ordinary income tax rate, an additional 7.65%, to compensate for payroll taxes if your earned income does not exceed this sum.
If you exercise 5,000 options at a $2 per share exercise price, but the market price is $3, the bargain factor is $5,000 ($1 price difference x 5,000 shares). Your W-2 reports $5,000 as the usual income for NSO taxation.
How to strategically and efficiently plan for ISO and NSO tax implications?
Irrespective of whether you obtain non-qualified stock options or incentive stock options, you should be aware that both are taxable and must be considered when filing. The most crucial thing to keep in mind is that after your options have been exercised, the outcome is that you own shares in the company and that ownership could help you supplement your normal income in the future. A Certified Financial Planner (CFP) can help you understand the complexity of stocks and tax rules to optimize your profits and minimize expenses when making the most of your employee stock options.
How does AMT affect ISOs and NSOs?
The AMT may reduce the ISOs’ financial safety net in various ways. If you decide to keep your ISOs, you must include the gap between the exercise and grant prices in your alternative minimum taxable income. Proceeding through exercising ISO and holding approach requires the use of AMT. It may be necessary for insiders of publicly listed corporations to hang onto the shares after it has significantly declined in value. The value of the shares when you might be able to sell them could be lower than the AMT tax owed on the first exercise. Individuals could escape the AMT trap and develop a solid tax and trading strategy by carefully arranging with a team of financial specialists.
Manage your company stock option plan with Eqvista!
If you want accuracy, simplicity, and clarity throughout the stock option distribution and valuation process, go with Eqvista. Shareholders and investors can manage cap tables, monitor valuations, equity shares, and much more with the help of Eqvista’s cloud-based company share management application. Clients can instantly grant and distribute shares to investors, founders, and employees using a single share administration platform.
To achieve precise tracking and prevent errors in a cap table, Eqvista provides FREE cap table software. We provide everything your company would require to manage its shares, from monitoring shares to ensuring that different equity requirements are met. To find out more and begin, register here.