We’re frequently asked about the differences between ISOs and NSOs. Let us try to clear up some confusion.
Stock option grants are the lifeblood of Shareworks Startup Edition – about 3 out of every 5 people who switch over to our solution do so because keeping track of options in Excel was simply no longer a viable option for them. Frequently, we're asked about the differences between ISOs and NSOs. This article should clear up some confusion and show how startup edition can help you stay compliant.
First, it’s important to note that NSOs (Nonqualified Stock Options) and ISOs (Incentive Stock Options) are largely constructs of the tax codes and therefore, it would be best to consult with a Certified Public Accountant when making any of these decisions for yourself or your company. Secondly, for the above reason, this article will not be all inclusive, but will cover the basics and focus on how our software can help.
With those disclaimers stated, let us dive in. ISOs have many tax advantages over NSOs for employees, but with these advantages come stricter rules in regards to the granting of ISOs. Therefore, it’s probably best to begin with NSOs as they are easier to understand.
Any number of NSOs can be granted to anybody (employee or non-employee). There are no restrictions on what the strike price can be, but any strike price less than than the current fair market value (FMV) of the stock will be considered ordinary compensation (not capital gains). For instance, if you are granted 1,000 shares with a strike price of a penny, but the current value of common stock is 50 cents, you have just received $490 in compensation. However, this compensation is recorded as it vests. So, with a vesting plan where 25% vests annually on the anniversary of the grant date for 4 years, there is no initial compensation. But on the first anniversary there is $122.50 of compensation (25% of $490) as there is on the 2nd anniversary and so on. This isn’t the only expense that the company will book throughout the grant’s vesting life, but is an additional form of compensation that needs to be included when an NSO is granted below it’s fair market value. There are also some penalty taxes that may apply, and for this reason, it is common to grant NSOs with a strike price at least equal to the fair market value.
Upon the exercise of an NSO, an individual is expected to show ordinary income equal to the value of the stock at the time of exercise minus the value at the time of grant. Returning to our example, let’s say that five years later, all of the shares have vested and the individual decides to exercise them. But during the past 5 years, the company has done very well and the FMV of its stock is now $5.00. This individual would be expected to pay ordinary income tax on $4,500 worth of compensation ( [5.00-.50] * 1,000] ). Any future gains from an NSO due to the sale of the stock would then be treated as long term or short term capital gains, depending on how long the stock was held after the exercise.
Now let’s take a look at how ISOs differ from NSOs. There are three major differences:
- ISOs can only be granted to employees
- The strike price must be at a minimum equal to the FMV of the underlying stock at the time of grant (or 110% of the FMV for shareholders who own over 10% of the company)
- An employee can only vest $100,000 worth of ISOs in a given calendar year.
There are several other minor differences, but we won’t go into them here. The biggest benefit of holding an ISO is that, upon exercise, an ISO does not trigger a taxable event (but it does count towards the Alternative Minimum Tax). Any gains upon the sell of the stock will be counted as long term capital gains (if the asset is held for at least 2 years after the date of grant and 1 year after the date of exercise).
Now, when discussing ISOs and NSOs with customers, they often ask if our software can automatically alert them when an employee’s $100,000 ISO limit is reached. The answer is “Yes, it can!” Our Cap Table Auditor alerts you when an employee has over $100,000 worth of ISOs vesting within a given year.
The Cap Table Auditor does make one assumption that you will want to manually check. It assumes the strike price of any option is equal to the FMV at the day of grant (as this is the case in 99% of situations – rarely are ISO’s issued with a strike price higher than the FMV).
If you find that you have accidentally exceeded the $100k limit, it’s okay. There is generally no need to reissue the option paperwork, but know that any grants that exceed the $100k limit should be treated as NSOs as that is how the US Government views them. In startup edition, you will want to perform a transaction on the offending option grant, transferring shares from the ISO to a new NSO. It is important to do this in order for the software's stock option expense tool to expense your options appropriately.
Hopefully, this post has cleared up any confusion surrounding ISOs and NSOs. If you would like to see a more detailed breakdown between ISOs and NSOs, click here.