Comparing Incentive Stock Options and Non Qualified Stock Options

Has your employer offered you non-qualified stock options (NQSOs) or incentive stock options (ISOs) as part of an equity compensation package? If you’re lucky, maybe you even get to choose.

That’s not typical; usually, an equity offering is what it is. But in case you’ve been wondering how each works, here’s a summary to help you compare NQSOs vs. ISOs.

Non-Qualified Stock Options (NQSOs)Incentive Stock Options (ISOs)OverviewNQSOs are relatively easy to understand, with greater simplicity in how the bargain element (basically, your profit) is taxed at exercise. That said, because the bargain element at exercise is taxed as ordinary income, NQSOs may be less tax-efficient, and less preferred, to ISOs.ISOs are often the most tax-advantaged, but potentially complicated options to manage, especially since they entail planning for alternative minimum tax (AMT) and AMT credit, and qualified/disqualified sales. To obtain these tax benefits, you may also need to have cash available to purchase stock when you exercise your options.Tax Treatment at GrantThere is no tax impact when you are granted your options.There is no tax impact when you are granted your options.Tax Treatment at Exercise of OptionsIn the year you exercise your options, you’ll pay ordinary income taxes on the difference between the exercise (strike) price (usually the stock’s fair market value on the grant date), versus the fair market value on the exercise date. The spread is also subject to required Social Security and Medicare tax, if applicable.
The full spread is taxed, regardless of whether you exercise and hold stock, or exercise and sell stock.In the year you exercise your ISOs, there may not be a direct ordinary income tax impact. However, there is a reportable tax event and an adjustment for calculating AMT if you hold unsold shares past calendar year-end. If you exercise and sell ISOs in the same calendar year, you’ll likely be subject to tax at ordinary income tax rates.Cash Flow at Exercise of OptionsYou can often do a cashless exercise or a “sell to cover,” which means you don’t need to provide cash to exercise your NQSOs. Instead, exercised shares can be sold at exercise to cover the cost of the stock purchase and potential tax withholdings. A sell to cover will not alter your tax treatment at exercise.If you exercise and hold all shares: You’ll need to provide cash to buy stock shares at your exercise price and cover any AMT payments (at tax time, or via estimated tax payments).

If you exercise and sell all shares: You could reserve some of the proceeds to pay estimated taxes, and the remainder can be used to fund personal financial planning goals.

Hybrid approach: You could exercise and hold some shares, and exercise and sell others to create a sell to cover.

Tax Treatment at Final Sale of StockYou’ll incur a capital gain or loss at final sale. The gain or loss will be the difference between the stock’s final sale price versus its adjusted cost basis (often equal to the strike price PLUS the amount included as ordinary income). The proceeds are subject to short- or long-term capital asset rates, depending on whether you held the shares for a year or less (short-term) or more than a year (long-term) before selling them.For a qualified sale: The final sale is qualified if it’s at least two years after the grant AND one year after exercise. If so, the difference between the exercise price and final sales price is taxed at more favorable long-term capital gains rates, PLUS you may be able to recover earlier AMT paid by taking an AMT credit in the year a qualified ISO is sold.

For a disqualified sale: The final sale is disqualified if it does not meet the qualifying standards. If so, you’ll likely pay tax at some combination of ordinary income and capital gain tax rates, subject to the time between exercise and sale. AMT may also be due if you perform a disqualified sale that crosses two calendar years.

Tax WithholdingsAt exercise, income taxes are withheld at statutory rates (usually 22%, or 37% if reportable income exceeds $1 million). There is no tax withholding at final sale, so estimated payments may be advised.There are no income tax withholdings at exercise or at final sale. ISOs are not subject to Medicare or Social Security payroll withholdings either.83(b) TreatmentIf your options are eligible for early exercise, you can file an 83(b) election to pay ordinary income taxes on the spread at exercise, prior to vesting. If your company is early-stage with a low share price, you may pay fewer ordinary income taxes early on, than if you wait. In this scenario, an NQSO may offer more tax-saving opportunities than an ISO.If your options are eligible for early exercise, you can file an 83(b) election. However, since there are no ordinary income taxes due at exercise, the early exercise is only effective for calculating AMT.AvailabilityNQSOs can be offered to employees and others, such as contractors, advisors, etc.ISOs are only available to employees.If You Leave the CompanyYour ability to exercise remaining vested options will be subject to the terms in your employment agreement, which may offer a post-termination exercise window or options expiration date.You’ll need to exercise the vested options within 90 days after termination to retain ISO origin.MaximumsThere are no limits on award amounts.ISO awards are limited to $100,000/year of exercisable value.CommonalitiesAs described above, neither NQSOs or ISOs create a tax event at granting. Both also share similar characteristics with respect to their grant dates, vesting schedules, exercise (strike) prices, and expiration dates. And both options may expose you to concentration risk, or the risk of having too much wealth concentrated in a single stock. If your concentration risks are too high, you may want to prioritize reducing them over optimizing tax-saving opportunities. For example, even if it’s less tax-efficient, you may take a disqualified ISO sale, so you can more quickly reduce concentration risk by diversifying the proceeds into other assets as soon as possible.

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This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.

Non-Qualified Stock Options (NQSOs)

Overview: NQSOs are straightforward, offering simplicity in understanding how the bargain element is taxed at exercise. The bargain element is taxed as ordinary income, potentially making NQSOs less tax-efficient compared to ISOs.

Tax Treatment:

No tax impact at grant.
Ordinary income taxes at exercise, including Social Security and Medicare tax.
Cashless exercise or "sell to cover" options available.

Cash Flow:

Cashless exercise or sell to cover options.
Need cash to buy stock shares at exercise price if holding shares.
Proceeds from selling shares can fund personal financial goals.

Tax Treatment at Final Sale:

Capital gain or loss based on the difference between final sale price and adjusted cost basis.
Final sale qualified if two years after grant and one year after exercise.

Tax Withholdings:

Income taxes withheld at exercise.
No tax withholdings at final sale.

83(b) Treatment:

Incentive Stock Options (ISOs)

Overview: ISOs are tax-advantaged but involve complexities like planning for alternative minimum tax (AMT) and qualified/disqualified sales.

Tax Treatment:

No tax impact at grant.
Potential direct ordinary income tax impact at exercise and sale.
AMT considerations if holding unsold shares past calendar year-end.

Cash Flow:

Cash needed to purchase stock at exercise.
Proceeds can be used to fund financial goals.

Tax Treatment at Final Sale:

Qualified sale for favorable long-term capital gains rates if specific conditions met.
Disqualified sale may result in ordinary income and capital gain tax.

Tax Withholdings:

No income tax withholdings at exercise or final sale.
Not subject to Medicare or Social Security payroll withholdings.

83(b) Treatment:

83(b) election for early exercise only effective for calculating AMT.

Availability:

Only available to employees.

If You Leave the Company:

ISOs usually require exercising vested options within 90 days after termination.

Maximums:

ISO awards limited to $100,000/year of exercisable value.

Commonalities

No tax event at granting for both NQSOs and ISOs.
Similarities in grant dates, vesting schedules, exercise prices, and expiration dates.
Both may expose individuals to concentration risk, necessitating careful consideration of diversification strategies.

In conclusion, while the presented summary provides valuable insights, the nuances of NQSOs and ISOs warrant further exploration, and I encourage individuals to delve into more detailed resources for a comprehensive understanding. Always consult with financial, tax, and legal professionals for personalized advice tailored to your specific situation.

Comparing Incentive Stock Options and Non Qualified Stock Options - Zajac Group (2024)

Non-Qualified Stock Options (NQSOs)

Incentive Stock Options (ISOs)

Commonalities