Companies 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:
| Issue | ISO | NQO |
| 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? | No | Yes |
| 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? | No | Yes |
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:
- 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.
- It is easier for companies to simply have one type of award to explain to their service providers – NQOs.
- 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.
- NQOs are more transparent than ISOs because the tax withholding on exercise is more easily calculated.
- The spread on the exercise of NQOs is deductible to the employer.
By Bo Sartain May 16, 2013 - 7:03 am
Joe, great analysis. I like the chart. I’m going to link to this post in our stock option generation wizard as part of the help. Thanks!
By Ji Eun (Jamie) Lee May 17, 2013 - 4:22 am
Hi Joe, thanks for this informative chart! I’m also going to link to this post in my upcoming Startup Stock Options class presentation. Thanks!
By Bill May 17, 2013 - 12:04 pm
Joe, great summary. I agree on 3. It is very rare for someone to satisfy the holding periods and typically if they did, it is because they early exercised and would have satisfied the period anyway.
For mid-sized and larger companies generating real revenue, the deduction in Item 5 is huge. I tend to see companies shift away from ISOs once they have enough revenue to get a finance person who understands tax benefits. Even if the deduction just ends up adding to a pile of NOLs, it is valuable to the employer particularly when the employee is unlikely to benefit from the ISO.
In any state other than Washington AMT in 1 is usually a killer as well. With no state income tax, it seems AMT strikes at least somewhat less here for mid-level employees.
By Peter Evanson June 27, 2013 - 12:10 am
Hey Joe, Really Nice summary and the chart you provide very helpful for stock options. This is the perfect one, what is required to make money in this trading market. Thanks!
By Josh January 27, 2015 - 1:49 pm
Hi Joe, nice site you have here, thanks for sharing your insights. Given the end of the year tax preparation I am struggling to figure out what I need to give to our employees here are the 3 examples of types of exercises during the year:
1.) Normal ISO Exercise once shares vested – I have prepared Form 3921
2.) Early Exercise of ISO – Section 83b elected at time of exercise (strike price = FMV) – do I also need to prepare a 3921?
3.) Early Exercise of NQO – Section 83b elected at time of exercise (strike price = FMV) – Anything else that I need to file (ie. 3921, etc.?)
By Joe Wallin February 27, 2015 - 8:55 am
Sorry for the late reply. Would be happy to chat with you on the phone about this if you like. 206 669 0997
By Lydia January 19, 2016 - 4:02 am
Hey Joe,
Thanks for the explanation but seeing as how so many Start-ups are using employees or contractors accross international borders, I’d really appreciate a break down for how NQSOs are treated for citizen and non-citizen non-residents. In our company, the employees of a consulting firm have stock in the US commpany we consult. We are all scratching our heads about how this will effect our personal taxes as some of us are US citizens living in Europe and some are European citizens also living in Europe.
Thanks for any clarification.