Stock options, such as the Incentive Stock Option (ISO) and the Non-Qualified Stock Option (NSO), are an important tool to incentivize employees, contractors, and consultants hired by a startup to work at their top capacity. These stock options provide workers with the right and opportunity to purchase shares in the future at the (theoretically) lower price that is set at the moment the stock is granted. Of course, the assumption here is that the company’s stock will grow and become more valuable in the future. However, the difference between and ISO and NSO is tremendous and it is therefore critically important to distinguish the two in order to determine which option is preferable for a startup to grant.
The primary difference between an ISO and NSO are the conditions of their taxation. For an ISO, taxes are not due until the recipient of the stock option sells the stock. Consequently, less taxes are (often) due for an ISO because no taxes are owed at the time of exercise. Conversely, stock from an NSO is taxed two separate times—(1) when the stock is exercised and (2) when the stock is sold. This means that the difference between the fair market value of the stock and the price of the exercise is considered regular income. This may become problematic if the stock recipient is unable to sell the non-liquid stock because the stock will still be taxed.
Regulations and Restrictions
ISOs are subject to the requirements of Section 422 of the Internal Revenue Code, which states that (1) ISOs are not transferable except in the case of the stock option recipient’s death, (2) a maximum of $100,000 worth of stock can be exercised per year, and (3) ISOs are for employees only. Additionally, if a stock option recipient owns more than 10 percent of the company, the exercise price of the option must be at least 110 percent above the fair market value. Although these restrictions are not stipulated for NSOs, this stock option adheres to Section 409A (determined by independent experts). Notably, here, the board of directors determines the valuation of ISOs. Further, NSOs can be granted to others involved within a company besides (and including) employees, such as directors, consultants, and contractors.
Finally, ISOs and NSOs are similar in that both stock options must be granted with an exercise price that is greater than or equal to the fair market value. Ultimately, ISOs are more rigid than NSOs and any ISO that no longer meets all of the requirements to be classified as an ISO automatically become an NSO.