If you’ve read our Employee Stock Options – The Beginner’s Guide Part 1, you should already be familiar with the stock option basics, including the terms exercise price, post-termination exercise period (PTEP), and vesting period.
Now, we’re going to focus on the differences between the two most common types of options – ISOs and NSOs – and discuss how they could impact your choices to exercise your options and eventually sell your shares.
ISO stands for incentive stock option. ISOs can only be granted to employees and can’t be transferred to family members or friends. Arguably, the best thing about ISOs is that they are not subject to income tax upon exercise. Additionally, ISO holders benefit from not being subject to Social Security or Medicare taxes on these options. There are other tax benefits upon disposition as well, as long as you follow certain IRS rules.
NSO, also known as NQSO, stands for non-qualified stock option. NSOs can be offered to employees, as well as to contractors, consultants, and directors. NSOs are taxed as ordinary income and are subject to Social Security and Medicare Taxes. Tax withholding is due at the time of exercise, and additional quarterly estimated tax payments may be necessary if withholding is insufficient.
ISOs and NSOs are two types of stock options that can be offered to company employees, allowing them to purchase a specified number of shares at a predetermined price and participate in the company’s potential future success.
However, different rules and regulations apply to ISOs and NSOs – read on to learn about the key differences between them.
ISOs can only be granted to company employees, and many private companies (and around 80% of private companies in Silicon Valley) choose to grant ISOs to their employees. In contrast, NSOs, the less popular form of equity compensation, can also be granted to other service providers, such as contractors, consultants, and non-employee directors.
ISOs cannot be transferred by the employee to third parties, including family members or friends (except upon death). NSOs, on the other hand, can be transferred to others under certain conditions, as set by the employee’s stock option agreement.
As covered in the Employee Stock Options – The Beginner’s Guide Part 1, employees usually have a limited time period (known as the post-termination exercise period or PTEP) to exercise their options once they leave the company. In most cases, ISOs must be exercised within 90 days after the termination date, while the time frame for exercising NSOs is more flexible and set by the employee’s stock option agreement.
Perhaps the most important difference between ISOs and NSOs lies in the way that they are treated by the IRS:
To qualify for this preferential tax treatment, ISOs need to meet the previous requirements (regarding eligibility, transferability, and the PTEP), as well as the following conditions:
In the next section of this guide, we dive into how these differences play out during the different stages of the options’ life cycle.
Neither ISOs nor NSOs are taxed at the time of option grant.
ISOs are also not taxable at the time of exercise unless the transaction triggers the Alternative Minimum Tax (AMT) (which will be discussed in a future post). In contrast, the difference between the exercise price and the fair market value of NSOs is treated as ordinary income at the time of exercise, and taxes are due at that time.
When the shares are ultimately sold, the difference between the sale and exercise prices is treated as capital gains (or loss) for ISOs. For NSOs, however, the capital gains tax is applied to the difference between the sale price and the fair market value at exercise.
Let’s continue our example from Part 1 of the guide:
You’re an employee at FuzzyBear Inc. You’ve been awarded 8,000 stock options, with an exercise price of $0.50 and a four-year vesting period.
Here’s a step-by-step outline of what you’d typically have to pay:
*Note: There are ways to reduce the amount of tax payable on your ISOs or NSOs. In general, it’s usually best to hold your shares for at least 12 months to reduce your taxes. However, there can be reasons to sell early, such as the need to access urgent cash or if you expect a large drop in the stock’s value. We’ll cover this topic in an upcoming post, so stay tuned!
Choosing a time to exercise your stock options is tricky, and falls anywhere between the time they vest and their expiration date. We will discuss this in detail in a future post, taking into account the different tax implications for ISOs and NSOs. In the meantime, here are a few questions you should ask yourself before choosing to exercise either type of option, based on what we’ve learned so far:
Next, you’ll need to carefully consider your financial situation and look into the possible tax implications for exercising your options, holding on to your shares, and selling them.
Whether you have NSOs or ISOs, read the next installment of the Employee Stock Options Guide for more guidelines from EquityBee on how to fund your stock options and estimate your tax obligations.