Incentive Stock Options vs. Nonstatutory Stock Options

Learn more about the two types of stock options dominate today's employee stock plans: ISOs and NSOs.

Many companies use employee stock plans as part of their incentive and benefits packages. Today options are not used as much by young and emerging companies, and they're not offered in lieu of a competitive salary. But they can still play an important role in engaging employees and winning their long-term support. Read more about the role that stock option incentives can play in your company and how you might structure your offerings.

Two types of stock options dominate today's employee stock plans: statutory options, also referred to as incentive stock options, or ISOs, and nonstatutory stock options, or NSOs.

A key difference between the two types of options is the way they are taxed. With an ISO, as long as certain conditions are met (see Key ISO Features, following), employees don't have to pay tax at the time of the grant or when they exercise their options; they pay tax when the stock is sold. Employees owe capital gains tax on the spread -- the difference between the grant price and exercise price -- but neither the employer nor the employees pay Social Security or Medicare taxes on the spread.

NSOs, which can be granted to employees and others, don't receive such favorable tax treatment. If the fair value of the shares is significantly greater than the option exercise price, the optionee could face a substantial federal tax obligation -- even if he or she still owns the stock (see Key NSO Features). And, when an NSO is exercised, both the employer and the optionee owe Social Security and Medicare taxes on the spread.

There are arguments for and against ISOs and NSOs. Consider the key features of each option type and be sure to consult your financial advisor and attorney before choosing one for your company.

Key ISO Features

• Only employees can be granted ISOs.

• No tax consequence is incurred at the time of grant or exercise of the ISOs (except for the possible application of the alternative minimum tax), and if the requisite holding periods are met, only a capital gain (or loss) will be recognized upon sale of the stock acquired upon exercise of the option.

• The aggregate fair market value (determined at the time of grant) of stock for which the options are exercisable for the first time by the option holder during the particular year can't exceed $100,000.

• To receive the favorable tax treatment, the options must be exercised within three months after termination of employment.

• The stock option is not transferable.

• The exercise price must generally be equal to or greater than the fair market value of the stock at the time of grant.

• For the optionee to achieve capital gains treatment on the gain, the stock must be held for more than one year from the date of exercise and more than two years from the date the option was granted; otherwise the gain at the time of sale will be taxed at the less favorable ordinary income tax rate.

Key NSO Features

• In addition to employees, consultants, agents, nonemployee directors, independent contractors and other persons can be granted nonstatutory stock options.

• For tax purposes, the option holder generally recognizes ordinary income at the time of the exercise of the option in an amount equal to the excess, if any, of the stock's fair market value over the option exercise price. For example, if the optionee has options to acquire 10,000 shares of stock at $1 per share, and he exercises the option at the time the stock is worth $3 per share, he has to indicate on his tax return income of $20,000 in the year of exercise ($3 minus $1 times 10,000). This is the case even if the optionee chooses not to sell the stock.

Read Vesting Schedules for Stock Options to get guidance on structuring a plan.

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