Incentive Stock Options vs. Nonqualified Stock Options

ISO vs NQOCompanies 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 ISOs and NQOs?

The table below summarizes the primary differences:

IssueISONQO
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 tax purposes; but spread is taxable for alternative minimum tax purposes (“AMT”). Exercise NOT subject to employment tax withholding.Yes for ordinary income tax purposes, and is subject to income and employment tax withholding. No AMT consequences.
Employment tax on exercise?NoYes
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?NoYes

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:

  1. 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.
  2. It is easier for companies to simply have one type of award to explain to their service providers – NQOs.
  3. 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.
  4. NQOs are more transparent than ISOs because the tax withholding on exercise is more easily calculated.
  5. The spread on the exercise of NQOs is deductible to the employer.

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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  • http://www.venturedocs.com Bo Sartain

    Joe, great analysis. I like the chart. I’m going to link to this post in our stock option generation wizard as part of the help. Thanks!

  • http://www.jieunjamie.com Ji Eun (Jamie) Lee

    Hi Joe, thanks for this informative chart! I’m also going to link to this post in my upcoming Startup Stock Options class presentation. Thanks!

  • Bill

    Joe, great summary. I agree on 3. It is very rare for someone to satisfy the holding periods and typically if they did, it is because they early exercised and would have satisfied the period anyway.

    For mid-sized and larger companies generating real revenue, the deduction in Item 5 is huge. I tend to see companies shift away from ISOs once they have enough revenue to get a finance person who understands tax benefits. Even if the deduction just ends up adding to a pile of NOLs, it is valuable to the employer particularly when the employee is unlikely to benefit from the ISO.

    In any state other than Washington AMT in 1 is usually a killer as well. With no state income tax, it seems AMT strikes at least somewhat less here for mid-level employees.

  • http://australianinvestmenteducation.com.au/ Peter Evanson

    Hey Joe, Really Nice summary and the chart you provide very helpful for stock options. This is the perfect one, what is required to make money in this trading market. Thanks!