ISO vs NSO Taxation
Are you new to employee stock options and wondering what the difference between ISO and NSO is?
If you’ve ever worked for a company, you will know that a lot of employers these days award employee stock options at one point or another. These options are a great thing as they give employees an opportunity to earn extra money whenever their organization’s stock increases down the line. Employee stock options are available in two main forms: Non-qualifying stock options or Incentive stock options.
Many people tend to favor incentive stock options because of their favorable tax treatment, something that non-qualified stock options do not offer. That said, the rules for both are quite different, which is a major reason behind the endless debates about iso vs nso taxation.
Incentive Stock Options (ISO) vs Non Qualified Stock Options (NSO)
Many people who are not familiar with nso tax treatment and iso taxation wonder what they are and what makes them so unique to each other. While NSOs and ISOs have plenty of differences, the main one is their tax treatment. Non qualified stock options are taxed multiple times, which is vastly different from how incentive stock option taxation. Below, we will discuss ISOs and NSOs and the things that make them different.
What is an Incentive Stock Option or ISO?
Companies, particularly startups, offer incentive stock options to their employees. These options are essentially a company benefit offering workers the chance to get hold of stock shares for discounted rates with the added benefit tax breaks on profits, ie. long term capital gains rate.
Contrary to popular belief, not every employee is a recipient of ISOs. Instead, employers only award the top high level workers and management. Some companies also use the terms “qualified stock options” or “statutory stock options” when referring to ISOs.
While every organization has different motivations behind their stock option offerings, most of them offer it to retain skilled and high performing workers to ensure the company’s overall growth in the long run. This in turn can significantly increase the company’s stock prices, proving to be quite beneficial for the incentive stock options holder and the company that awarded it.
ISOs taxation fall under two categories, qualifying dispositions and disqualifying dispositions:
- Qualifying dispositions: The ultimate disposition of shares is at least 1 year after exercising and two years after the options are granted. In this case the total gains falls under long term capital gains tax rates.
- Disqualifying dispositions: The ultimate disposition of shares is NOT at least 1 year after exercising and NOT two years after the options are granted. In this case the bargain element (difference between the fair market value on exercise price and exercise date) is subject to income tax rates, and the gain from the sale of stock is either short term gains (less than 1 year after exercise) or long term gains (more than 1 year after exercise).
What is a Non Qualified Stock Option?
Non-qualified stock options are different from ISOs in the sense that you have to make ordinary income tax payments on the difference between the price you pay for exercising the option and grant price. It’s commonly known that non qualified stock options are pretty straightforward compared to incentive stock options.
The reason why people call them “non qualified” stock options is because unlike ISOs, these options don’t meet every IRC requirement. Unlike ISOs, non qualified stock options offer workers the right to buy a particular amount of shares within a specified time period. Some companies offer NSOs as an alternative compensation while others offer it to give employees an incentive to remain loyal and achieve its various business targets.
In most cases, non qualified stock options tend to minimize the cash employees get during their employment. Typically, the rate of these options is similar to the market value of shares whenever the organization makes them available (also called grant date). Employees have to exercise these options within a deadline called “the expiration date”. If you fail to exercise these options within the date, your options will be worthless.
With non qualified stock options, there is always an expectation that share prices improve with time. This means that workers who hold these options can obtain stocks for discounts in case the exercise prices go below the market prices. Regardless, the employee has to pay income tax when exercising the option. And once exercised, employees can retain or sell their shares depending on their preferences.
As mentioned earlier, younger and up and coming businesses that don’t have the excessive amount of resources that others do often utilize NSOs instead of massive salary increases. Employers also utilize it as a tool for recruitment, especially when hiring highly talented individuals.
What are the Differences between ISO and NSO?
As mentioned previously, there is a lot of difference between ISOs vs NSOs. Whether it is the NSO tax treatment or ISO taxation, both employee stock options are very unique in how they work and their benefits. Tax liability, when they are due, their eligibility, and how they benefit a company can vary depending on the type of stock option you have.
Let’s take a close look at some key factors that make these stock options different.
- Eligibility: When talking about incentive stock options vs non-qualified stock options, the main difference between them is that companies can only issue ISOs to employees. NSOs, on the other hand, are different as organizations can offer them to service providers, independent contractors, non-employee directors etc.
- Taxes Due: In the case of incentive stock options, employees or holders don’t have to worry about paying tax until they sell their options. However, you have to pay your taxes immediately after exercising your non qualified stock option. The main reason for this is that companies consider NSOs as a part of their employee’s income. So unlike incentive stock options, NSOs introduce taxation long before a holder sells his or her stock.
- Tax Liability: In most cases, ISOs often result in less taxes, especially when their exercise prices are around the fair market value. On the other hand, the strike price should be at least the fair market value from the grant date.
- The Benefit of the Company: If you look at things from a company’s perspective, you will understand that non-qualified stock options are significantly more beneficial when it comes to timely tax deductions. Why? Because companies can deduct the taxes as soon as a worker exercises their options. With ISO’s this won’t be possible, which is why many consider non qualified stock options to be a practical choice.
- Rigidity: Incentive stock options come with a fair amount of operational rigidity. For example, in most situations, like those where a worker doesn’t have the inventive stock option for the minimum holding period. In this scenario, ISO becomes an NSO. If you don’t hold the stock for a minimum of two years from the grant date and one year from the exercising date, it will effectively become a non qualified stock option.
- Restrictions: The main differences between incentive stock options vs non qualified stock options are present in their restrictions. NSO strictly abide by Section 409A. On the other hand, an ISOs valuation is not as stringent. In addition, incentive stock options are regulated under the internal revenue code’s section 422. For instance, you cannot transfer an ISO under any circumstance, unless it is due to the stock recipient’s death. With NSOs however, this is not the case.
- Exercise Period after Employment: The exercise period of these stock options is also what makes them incredibly different from each other. In the case of incentive stock options, you can exercise them within 3 months following your termination from the company. As mentioned before, you can only extend this period in case of disability or death.
In contrast, an employee can exercise their non qualified stock option whenever they want, as long as it is before the stock’s expiration. It is also worth remembering that your ISOs will only be applicable while you are working with your company. NSOs, on the other hand, don’t require you to remain employed.
These are just some of the examples that showcase the main differences between iso and nso. Employers take these things under consideration before choosing the right stock options for their workers.
Here are the differences between ISO vs NSO in the table below:
|Eligibility||Employee||Any service providers|
|Taxes Due||At sale of shares||At exercise of options & sale of shares|
|Tax Liability||Subject to long term tax rates||Subject to income tax rates|
|Company Benefit||Tax deductions on sale of shares||Tax deductions at exercise of options|
|Rigidity||More rigid, strict set rules ($100k rule)||Less rigid, more flexibility|
|Restrictions||Follows IRC 422||Follows IRC 409A|
|Exercise Period||Usually within 3 months of termination||Usually no set time frame after termination|
ISO vs NSO Taxation
ISO vs NSO taxation has been a popular topic of discussion among their respective holders. Both of these stock options are taxed in different ways, and no matter which one you receive, knowing how their taxation works is essential for financial planning and getting the most out of your options. Let us discuss how incentive and non qualified options are taxed.
How Incentive Stock Option or ISO taxed?
One of the main benefits of incentive stock options is the absence of taxable income for employees during the grant and in cases of timely exercise. That said, the difference between the exercise price and stock’s value is adjustable for alternative minimum tax. Any gain or loss after a holder sells the stock later becomes long-term gain or loss.
For those who don’t know, the gain or loss is essentially the difference between the tax basis and the sales realized amount, which is the amount one pays when exercising. You will ruin your chances of favorable tax treatment with disqualifying disposition.
How Non Qualified Stock Options or NSO taxed?
The contrast between the stock’s value at exercise price and the stock when exercised is the ordinary income. Incomes can be subject to employment taxes and income tax withholding if realized on exercise. Also, when a holder sells the stock later, it becomes a capital gain or loss.
Here are the differences between ISO vs NSO taxation in the table below:
|Tax Rate||Possibility for Long Term Tax Rate||Regular Income Tax Rate|
|Tax on Exercise of Options||No||Yes|
|Tax on Sale of Shares||Yes||Yes|
AMT or Alternative Minimum Tax
The term “alternative minimum tax” is quite common when discussing about individuals who receive a high economic income. At its core, AMT essentially places a limit on the tax percentage a filer has to pay, regardless of the credits or deductions they claim. The government imposes alternative minimum tax for any taxpayer earning above particular thresholds. Let us understand what AMT or alternative minimum tax really means.
What is Alternative Minimum tax or AMT?
As the name suggests, alternative minimum tax is a different way to calculate tax obligations. Its main purpose is to ensure everyone, particularly people who receive high incomes, pay the right income tax amount. If you earn an amount that is higher than the amount set for AMT exemption, then you should consider calculating your alternative minimum tax and ordinary income tax and pay the higher of these two.
AMTs don’t offer as many tax breaks and deductions, which means that there is a good chance of getting higher taxable income. You may need to pay AMTs in the following situations:
- Your income is high
- You are married
- You have multiple children (more than three)
- You reside in a high income tax state
- You bought incentive stock options recently but did not sell them
Does Alternative Minimum tax affect ISO or NSO?
Incentive stock options are also subject to AMT, which is another way to calculate taxes for some tax filers. Alternative minimum tax could tax the incentive stock option holder on the spread realized upon exercising, despite the reward’s favorable tax treatments.
Last thoughts on ISO vs NSO tax
Understanding the fundamentals of incentive stock options vs non qualified stock options is essential to using them correctly. Both of them can be advantageous for employers and employees if provided and exercised at the right time. With the information discussed in this piece, you should have a better idea of which option would benefit you the most. But what is the best way to record them?
Eqvista is one such software that can handle the issuing and recording of your ISOs and NSOs in your company. Our advanced platform can help your company manage the equity stake of your options holders, and share these details with hundreds of people at one time. Here are some other important features of Eqvista. To know more about the Eqvista contact us today!