Your startup compensation package should include stock options (ISOs or NSOs) for a reason. It helps to compete for top talent in the job market. It’s also a great chance to reward those employees who have joined early and motivate them to stay longer.
Most founders don’t get a guide on equity when launching a business. With business plans, financial models, and fundraising being top of mind, equity decisions often get pushed aside. So, when it comes to choosing ISO vs NSO stock options for their employees, they typically get lost.
While it can get confusing, in reality, it’s not rocket science. With this article you’ll get the basics of ISO vs NSO stock options. It covers their lifecycle, tax details, major pros and cons, and strategic tips on how to choose the best option for your startup.
What ISO vs NSO stock options are, and how they work
Stock options are a financial instrument that gives employees, contractors, or investors the right—not the obligation—to buy company shares at a set price (known as the exercise or strike price) within a certain time period.
Stock options typically come in two main forms: ISOs, meaning incentive stock options and NSOs, meaning non-qualified stock options. Although similar in offering employees the chance to buy company shares, ISOs vs NSOs differ in who can receive them and tax rules.
Incentive stock options, or simply ISOs, are a tax-advantaged stock option with restricted eligibility*—only employees *are eligible to get them. ISOs get favorable tax treatment compared to NSOs if certain conditions are met.
Non-qualified stock options, or NSOs, have more flexible eligibility but no tax benefits. Unlike ISOs, NSOs can be given to employees, contractors, advisors, and other service providers as part of their compensation. However, when exercised, NSOs are hit with ordinary income tax and later with capital gains tax when sold. That’s why they’re called “non-qualified,” as they don’t get the tax perks that ISOs do.
Lifecycle of ISO vs NSO
ISO and NSO stock options typically go through four key stages: granting, vesting, exercising, and exiting. Let’s break them down.
- Granting ISO vs NSO stock options
When granting both NSO and ISO stock options, you send a stock option offer letter or equity agreement with the key details: number of options, expiration date, exercise price (or strike price), and vesting schedule. This document lays out the terms and conditions, ensuring everyone knows how the NSO and ISO stock options work from start to finish.
- Vesting ISO vs NSO stock options
Granting an ISO or NSO stock option doesn’t mean letting own it. To earn the right to exercise (and eventually sell) it for profit, a recipient must meet certain vesting conditions, like hitting milestones or staying with the company for a specific period. Once these conditions are met, a recipient gains full rights over their ISO or NSO options.
Vesting usually occurs over a certain period, known as a vesting schedule.
Example:
Let’s say employee X was granted 100 stock options at a fair market value (FMV) of $5 each in June 2020. Here’s how it works: 25% of the options vest after a one-year cliff (aka probation period to make sure the employee is a good fit). The remaining 75% vest equally over the next four years.
- Exercising ISO vs NSO stock options
Here’s what happens at the ISO vs NSO exercise. Once the ISO or NSO options vest, it’s time to exercise them. Both ISOs and NSOs have an exercise price set at the FMV on the grant date. The timelines, however, differ.
Grant ISO or NSO stock options to employees at $5 each, and they’ll exercise them at that price, regardless of current market value. Even if the ISO or NSO stock hits $15 per share, they still pay $5.
The type of stock options influences its exercise period: NSOs typically have longer exercise periods, while ISOs are limited to 10 years. Here’s what it might look like:
With NSO stock options, employees can wait as long as they want for the right moment. In such a way, they can maximize long-term capital gains if the company’s value rises.
Conversely, ISO stock options must be exercised within 10 years (sometimes just 5). Miss the window, and options are lost (they typically return to the option pool).
This ISO rule is for those who own less than 10% of the company. But what if someone owns more than 10%? In this case, special conditions apply:
Exercise price: Minimum 110% of FMV on the grant date.
Exercise period: Must be exercised within 5 years after the grant date.
These rules prevent 10% of owners from getting a crazy good deal.
So, regular employees exercise their ISO stock options at $5 each, but 10% of owners need to pay $5.5.
- Exiting or selling ISO vs NSO stock options
Startups thrive on high-growth liquidity events like IPOs or M&As, where ISO and NSO options turn into shares, and employees cash in big.
But it’s also the most tax-heavy stage, especially for ISO stockholders. Hold ISOs long enough, and you get lower long-term capital gains taxes. Sell your ISO stock too soon, and you could face higher ordinary income taxes and possibly the Alternative Minimum Tax (AMT). It’s all about hitting the sweet spot*.*
What happens to ISOs vs NSOs when an employee leaves?
When an employee leaves, the fate of their ISOs vs NSOs hinges on the stock option plan and employees’ departure details:
Both ISOs and NSOs must be exercised within 90 days post-departure.
If employees exercise their ISO stock options within this period, they might still qualify for favorable ISO tax treatment if other conditions are also met. If employees miss the window, the ISOs convert to NSOs, losing their tax perks.
Exercising NSOs after leaving doesn’t change their tax treatment.
If employees don’t exercise NSOs in time, they expire and are forfeited.
Difference in ISO vs NSO tax treatment
Both ISOs and NSOs are subject to taxes. While the tax treatment of ISOs is more favorable (under certain conditions), NSOs are always taxed. The good news is that ISOs and NSOs AREN’T taxed on grant or vesting if the exercise price equals FMV on the grant date.
NSO stock options: when and how they are taxed
NSO stock options are subject to income and employment taxes during exercise and capital gains tax when the shares are sold.
It’s important to note that NSO options must follow tax rules to meet IRS (Internal Revenue Code) requirements. If not, Section 409A imposes a 20% penalty and interest on the option holder. Therefore, the NSO exercise price must at least meet the FMV when granted.
During NSO exercise
The difference between the FMV at exercise and the exercise price (called the spread) is taxed as ordinary income.
Example:
Let’s imagine employee X decides to exercise 100 NSO stock options at $5 each while the FMV is $15 per share. The spread here is $1,000 ($15 per share – $5 per share = $10 spread per share; $10 x 100 shares = $1,000). Therefore, X must pay income and employment taxes on $1,000.
When employees exercise NSOs, you need to withhold income tax, Social Security, and Medicare taxes on the spread and you can deduct this as a business expense.
When NSO stock is sold
The tax rate depends on how long NSO stock options were held.
Selling NSO options within a year brings the need to pay short-term capital gains tax on the profit (sale price minus FMV at exercise). If NSO stock options are held over a year, they’re taxed as long-term capital gains, typically at a lower rate.
ISO stock options: when and how they are taxed
For ISO stock options, there are no taxes during exercise if certain conditions are met, but there is capital gains tax when selling the shares.**
ISO stock options have quite a complex tax treatment, so let’s break it down into key scenarios.
The most beneficial scenario with tax benefits
To qualify for the best ISO tax treatment, employees must meet the following conditions:
Holding shares for at least one year post-exercise;
Holding shares for two years from the grant date;
The optimal incentive stock options example:
You granted 100 ISO stock options to employee X in June 2020, which X exercised in June 2022. It means that X must hold the shares until June 2023 for a lower capital gains tax rate. In this case, X saves much money compared to ordinary income tax rates.
There’s no need for employers to withhold taxes. Additionally, there’s no tax deduction if employees qualify for long-term capital gains.
If we’re talking about which stock options (ISO vs NSO) have a clear tax advantage, it’s definitely ISOs. But there’s a catch. A large spread between the exercise price and the FMV can cause employees to hit the Alternative Minimum Tax (AMT) in the year of ISOs exercise. However, even with the potential AMT, ISO stock is generally more tax-friendly than NSO stock.
ISO vs NSO early exercise
If employees exercise and sell ISO stock options in the same year, they lose out on tax benefits. This is called a disqualifying disposition. The spread is taxed as ordinary income, just like NSOs, and any profit from the spread gets hit with short-term capital gains. The upside? Employees avoid dealing with the AMT.
NSO stock options don’t offer the same tax perks as ISO stock options, so the timing of NSO exercise doesn’t give any significant tax advantages. Anyway, NSO options fall under ordinary income tax.
As an employer, you don’t need to worry about withholding taxes during ISO exercise. However, if employees make a disqualifying disposition (their ISOs turn into NSOs), you get to claim a tax deduction for the ordinary income. This can help reduce your taxable income.
If an employee goes over the ISO stock limit
Employees also need to watch the $100,000 limit on ISO stock options to keep their tax perks. They can only exercise up to $100,000 worth of ISOs in a year. Anything over that turns into NSO stock and gets taxed differently.
As an employer, you’ll need to withhold taxes on the excess options and can claim a tax deduction for the reported income.
So, should you grant ISO vs NSO?
If you still hesitate about which stock options (ISO vs NSO) to grant your employees, run through the pros and cons of each type.
Non-qualified stock options
Pros:
Unlike ISO, NSO options are flexible. You can grant NSO stock to employees, directors, contractors, and others.
You can deduct the income reported by employees at exercise.
You’ll face fewer restrictions, so compliance will be easier.
NSO stock options can be issued by corporations and LLCs.
Cons:
Employees will pay higher taxes on the spread.
If they sell NSO options within a year, their gains will be taxed at higher short-term rates.
Incentive stock options
Pros:
The main advantage of ISO vs NSO is that employees get lower taxes if they meet holding periods.
No Social Security or Medicare taxes on the spread at exercise.
Cons:
You can grant ISO stock options only to employees.
The main disadvantage of ISO vs NSO is that employees might face the Alternative Minimum Tax (AMT) if the spread is significant.
There are complex rules to follow, like the $100,000 limit and holding periods.
ISO stock can be issued only by S-Corps and C-Corps.
The ISO vs NSO bottom line: While ISO stock options offer tax perks, NSO options are more widely used and easier to manage. That’s why you won’t see ISO stock as often in the startup world. While ISOs have more complex eligibility rules and specific holding periods required to get the tax perks, NSOs are simpler and more flexible. This makes them a go-to choice for startups.
ISO vs NSO stock options are a nuanced type of compensation. Getting the difference of ISO vs NSO requires founders to be legally-savvy. You need to proactively communicate the value of an equity package to your employees. You also need to keep track of to whom and when you’ve issued these options. At the end of the day, these are the things you, as a startup founder, may have nightmares about.
A simple wisdom is this, rest your ISO vs NSO decision on your startup’s unique needs and get a handle on your cap table earlier than later. When choosing the best ISO vs NSO option, consider your goals, administrative capacity, and employee preferences. And remember that expert advice makes a big difference here. So, don’t hesitate to reach out to our Waveup team and join the ranks of our satisfied clients whom we’ve helped build and fund their startups across 80 verticals.
FAQs
What is the difference between incentive stock options vs non-qualified stock options?
If we’re talking about ISO vs NSO difference, it’s all about eligibility and tax treatment. A startup can grant ISO stock options only to its employees. If employees hold onto their shares long enough, they can benefit from tax perks. In contrast, anyone, be it an employee, an advisor, or a contractor, can receive NSO stock options, which usually come with higher taxes and fewer benefits.
What are the holding period requirements for ISO vs NSO?
The situation with holding periods for ISO vs NSO options differs. If we’re talking about ISO stock options, employees must hold ISOs for two years from the grant date and one year from the exercise date if you want to get the tax perks. Conversely, NSO stock options have no special holding periods and can be exercised and sold at any time. Unlike ISO, NSO options don’t come with tax perks and are taxed as ordinary income at exercise.
What happens to ISO vs NSO when holding periods aren’t met?
Selling ISO stock options before meeting the holding period triggers disqualifying disposition. This means that the spread between the exercise price and the sale price is taxed as ordinary income. Unlike ISOs, NSOs aren’t tied to holding periods because they are always taxed as ordinary income at exercise, regardless of when the stock is sold.
Why do employees prefer ISOs to NSOs?
When choosing between ISO vs NSO, employees are more likely to turn to ISOs because of potential tax perks. Employees just need to keep their ISO stock long enough.
What is better, ISO vs NSO, for technology startups?
If choosing between ISO vs NSO for tech startups, ISO stock options could be a better choice. They offer tax benefits and encourage employees to stay longer, which is very important for startups who want to build a committed team.