All posts tagged ISO

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.
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Stock Option Exercise Checklist

Stock Option Exercise ChecklistCongratulations, you’ve gotten your company off the ground.  You’ve incorporated, issued founder shares and filed 83(b) elections, adopted a stock option plan, granted stock options, and been working on your business for a while.  Now an employee who has been with you since the start wants to exercise a stock option that has vested in part.  What do you do?

Recommended Steps

I recommend that you take the following steps as you process each option exercise:

  • Review the stock option exercise notice; confirm that it is completed correctly and executed by optionee.
  • Make sure that you have all of the optionee’s original stock option paperwork signed and in the files (meaning, the notice of grant of stock option or stock option agreement).
  • Confirm that option was approved by the Board in minutes and/or a Board consent.
  • Confirm that your Rule 701 math was correct, and that you are operating within Rule 701′s limitations and conditions.
  • Was the optionee terminated and in connection therewith did the optionee execute a release of all claims?  If so, did the release terminate the stock option?
  • Confirm the tax status of the option being exercised—nonqualified stock option (NQO) or statutory (incentive) stock options (ISO)?  Is it in part an ISO and in part an NQO?
  • Make sure the optionee is only exercising with respect to vested options or options that are not vested but immediately exercisable.
  • Confirm Blue Sky securities law compliance. (In which state does the optionee reside? Are securities filings required?)
  • Does the Company have a repurchase option with respect to the shares?  Will the Company exercise its repurchase option?
  • Determine whether the Board of Directors needs to make a new determination of the fair market value of the shares to determine the tax withholding or ISO adjustment amount.
  • Calculate the tax withholding (including but not limited to federal income and federal employment) if the option is an NQO (if the option is an ISO, make sure employee understands AMT tax consequences and be sure to send notification of ISO gain to employee and IRS).
  • Make sure to obtain from the exercising optionee the strike price plus the tax withholding, if tax withholding is required.
  • Consider providing the optionee with disclosure of some of the material risks of buying the securities.  A bullet point list of risk factors, financial statements, for example.
  • Have Company counsel prepare a stock certificate and stock certificate receipt.
  • Update the Company’s capitalization table.
  • Make sure payroll is aware of the exercise and properly reports the exercise on wage statements/Forms W-2, or ISO adjustment notification.

Conclusion

Don’t rush through this process and miss an important step!

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What Type of Equity Incentive Should I Use?

Startups and emerging companies frequently have to answer this question: What type of equity incentives should they use to incentivize service providers? For C corporations and S corporations there are generally 4 possibilities:

Definitions

NQOs are stock options that are not ISOs under the Internal Revenue Code. Gain on exercise is ordinary income and subject to income and employment tax withholding.

ISOs are stock options that qualify for certain special tax benefits under section 422 of the Internal Revenue Code (no ordinary income tax on exercise—but watch out for AMT (alternative minimum tax)—and capital gain on sale if certain restrictions and 2 holding periods are met). Among other restrictions, ISOs:

  1. can only be granted to employees, pursuant to a shareholder approved plan;
  2. must have a term not greater than 10 years (or 5 in certain circumstances);
  3. must have an exercise price not less than fair market value as of the grant date (or greater in certain circumstances); and
  4. not more than $100,000 in value can vest in any 1 year.

By restricted stock, I mean actual stock issuances, subject to repurchase rights at cost (or similar restrictions), which restrictions lapse over a vesting period. By RSUs I mean units which entitle an award recipient to receive shares upon vesting.

And by phantom equity I mean a wide range of contractual arrangements (such as stock appreciation rights) that are not actual shares of stock, but are designed to approximate the rewards of stock ownership.

Awards

The type of equity award a company should grant its employees depends in part on the stage of the company.For very early stage companies the tax consequences of restricted stock can be favorable (employee starts capital gains holding period) and bearable (meaning the tax owed upon grant, if there are no repurchase restrictions, or in connection with filing an election under Section 83(b), if there are restrictions, is not too painful). However, once a company’s value has gone up, such that issuing stock from a tax standpoint is too expensive or too uncomfortable, I usually recommend companies use NQOs for the following reasons:

  • The potential benefits of ISOs (no tax on exercise (as opposed to ordinary income on the exercise of an NQO), and nothing but capital gain on sale) are rarely in fact realized.Usually the holding periods to obtain these benefits aren’t met, and the employee then has ordinary income when the stock is sold in a liquidity event;
  • The AMT consequences to an employee upon an ISO exercise are frequently more significant than expected (and being surprised that you owe more in tax than you expected is never good);
  • The company gets a tax deduction on the exercise of an NQO;
  • NQOs are less complex (you don’t have to worry about AMT adjustments, the consequences of not meeting holding period requirements, etc.);
  • NQOs are more transparent from a tax reporting perspective because you calculate and have to make estimated tax payments up front at exercise (which reduces the likelihood of a surprise at tax return filing time);
  • Restricted stock and RSUs are not as favorable as options because employees lose control over the timing of the incidence of the tax (if no Section 83(b) election is made at grant, restricted stock is taxable upon vesting (when the value may be significantly greater than at grant, meaning much more tax is owed than might have been initially expected), as opposed to an option which is taxable when the employee decides to exercise). Having some control over the timing of the incidence of the tax is important; and
  • Phantom stock or similar arrangements tend to be complicated and employees view them as inferior to actual stock options.

The table below summarizes some of the key federal income tax consequences of each of these types of awards. It is a high level summary only. If you want more detail, please contact me.

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