Companies and service providers to companies frequently confront this question. Which is better: an Incentive Stock Option (aka a statutory stock option) (an “ISO”) or a Nonqualified Stock Option (aka a Nonstatutory Stock Option) (an “NQO”)? What are the differences between these two types of equity awards?
The table below summarizes the primary differences:
Issue | ISO | NQO |
Eligibility Limitations: | Only employees (so, a nonemployee member of the board of directors can’t receive an ISO). | Employees and independent contractors are both eligible. |
Options taxable upon receipt? | No – as long as priced at FMV at grant. | No – as long as priced at FMV at grant. |
Options taxable upon vesting? | No – as long as priced at FMV at grant. | No – as long as priced at FMV at grant. |
Option taxable upon exercise? |
Not for ordinary income |
Yes for ordinary income tax purposes, and is subject to income and employment tax withholding. No AMT consequences. |
Employment tax on exercise? | No | Yes |
Annual limitation? | Yes; only up to $100,000 in stock underlying ISOs can become exercisable in any calendar year. | No |
Special rule for greater than 10% shareholders? | Yes; options to greater than 10% shareholders must be priced at least 110% of FMV and not be exercisable after the expiration of 5 years from the date of grant. | No |
Alternative Minimum Tax Applicable? | Yes, on the spread on exercise. | No |
Character of income on sale of stock? | Long-term capital gain, IF the two holdings periods are met. You have to have held the stock for 1 year after exercise, and for at least 2 years after the grant of the option. If you don’t meet these two holding periods, then the income is a mix of ordinary and long-term or short-term capital gain, depending on the spread at the time of exercise and appreciation (if any) and length of time between exercise and sale. | Either long term or short term capital gain, depending on how long the stock was held after exercise. |
Spread on Exercise Deductible to the company? | No | Yes |
Conclusion
I recommend NQOs over ISOs for the reasons I summarized in the article Should I Grant ISOs or NQOs?
To reiterate my arguments in favor of NQOs over ISOs briefly:
- ISOs are more complex and difficult to understand for a variety of reasons, including (a) the two holding periods, (b) the annual limitation, (c) the eligibility restriction, (d) the greater than 10% shareholder rule, (e) complexities associated with disqualifying dispositions, but most significantly because of the AMT consequences on exercise when there is a spread.
- It is easier for companies to simply have one type of award to explain to their service providers – NQOs.
- Most employees don’t meet the holding period requirements of ISOs in any event – because they wait to exercise until there is a liquidity event – so the primary benefit of ISOs – capital gain on sale of the stock – is not obtained.
- NQOs are more transparent than ISOs because the tax withholding on exercise is more easily calculated.
- The spread on the exercise of NQOs is deductible to the employer.