NSOs vs. ISOs: What You Need to Know

A common question we receive is: what are the differences between ISOs and NSOs? While we have already published articles that dive into ISOs and NSOs individually, we think it would be helpful to consolidate some information and compare these 2 types of stock options side-by-side.

Please note circumstances can vary wildly, so it is best to consult your CPA if you have specific questions about exercising and tax implications.

ISO v. NSO – Which type do companies usually grant?

This depends on the company. Incentive stock options can be granted only to employees of the respective company—not consultants or external vendors. Companies can grant a maximum of $100,000 per year in ISOs (note: this $100,000 valuation is determined by the strike price); any options awarded beyond this amount are automatically treated as NSOs.

NSOs can be granted to anyone involved with the company—consultants and external vendors included—and there is no limit on the amount that can granted.

ISOs v. NSOs – What are the differences in tax treatment?

The major difference between ISOs and NSOs is how each type of option is taxed, both at the point of exercise and the point of sale of the stock.

Let’s start with NSOs. NSOs do not qualify for special tax treatment under the IRS Revenue code (hence the term “nonqualified”). Simply put, you pay taxes twice when dealing with NSOs: at the point of exercise and at the point of sale. The spread (or difference) between your exercise price and the Fair Market Value (FMV) of the stock in question is taxed as compensation income, or ordinary income.

When you sell your shares, the spread between the stock price at the time of sale and the Fair Market Value (FMV) at the time of exercise is taxed at either the long-term or short-term capital gains rate, depending on how long you held your stock after exercising. Let’s explain this with a few illustrative examples:

NSO Exercise

NSO exercise price: $1
FMV at time of exercise: $5
Taxable income: the spread between the exercise price and the FMV at time of exercise is $4. This is treated as ordinary income and is taxed as such.

Post-Exercise Sale

FMV at time of exercise: $5
Price of Stock at the time of sale: $10
The spread between the FMV at the time of exercise and the price of stock at the time of sale is $5. This is treated as a capital gain (either short-term or long-term, depending on the holding period) and is taxed as such.

ISOs, on the other hand, can have numerous tax advantages compared to NSOs.

For an employee to receive these special tax benefits at exercise, they must meet certain requirements. If these requirements are met, the holder will pay long-term capital gains taxes, making ISOs significantly more tax efficient than NSOs.

It is important to note that at the point of exercise, (assuming the FMV is higher than the exercise price), the spread between the FMV and the exercise price is added to the holder’s income for the purposes of calculating the holder’s AMT (Alternative Minimum Tax – see an article covering this here.

At the time of sale, ISO holders can potentially trigger two different points of taxation and therefore two different components: capital gains income and ordinary income.

Note for clarification: Points of Taxation are different than Taxable Events. There is only one taxable event with an ISO – the time of sale. Within that event, are two potential points of taxation that we’ll explain. NSOs, on the other hand, have two taxable events: the time of exercise and the time of sale.

The spread between the selling price and the cost basis (typically, the exercise price unless there are AMT adjustments) is treated and taxed as one of these two incomes, depending on whether the holder meets the criteria for a “qualifying disposition”.

The criteria for a qualifying disposition are the following:

Holds the stock for more than two years from the grant date
Holds the stock for more than one year after the point of exercise
Was employed the by the grant issuing employer from the point of grant date to up to three months prior to the exercise date

If the disposition is qualifying, the difference between the selling price and the cost basis is treated as long-term capital gains and taxed as such. Additionally, if the holder is subject to AMT, the cost basis (price paid for the stock exercise) is reduced to reflect the FMV of the stock less the spread calculated previously. (Note: We have examples below to illustrate this if you’re feeling a bit lost.)

However, if the sale is not a qualifying disposition, the spread between the FMV and the exercise price is taxed at the higher ordinary income rate. The remaining difference between the disposition price and the cost basis (the FMV) is then treated as capital gains. It will then be treated as either short term or long term depending on the amount of times the shares were held (less than 1 year = short term, longer than 1 year = long term).

Here is an illustrative example:

Assuming Qualifying Disposition:

ISO Exercise:

ISO exercise price: $1
FMV at time of exercise: $5
Taxable income: No taxes are paid at the time of exercise (although AMT may come into play here

Post-Exercise Sale:

ISO exercise price: $1
Stock price at time of sale: $10
Taxable income: $9, treated as long-term capital gain

Assuming Disqualifying Disposition:

ISO Exercise:

ISO exercise price: $1
FMV at time of exercise: $5
Taxable income: No taxes are paid at the time of exercise (although AMT may come into play here)

Post-Exercise Sale:

ISO exercise price: $1
FMV at time of exercise: $5
Stock price at time of sale: $10
Taxable income: $4 at the ordinary income tax rate, $5 taxed at either the long-term or short-term capital gains rate, depending on amount of time stock was held.

Summary:

NSOs can be granted to anyone involved with the company and have no grant limit, while ISOs can only be granted only to employees and have a $100,000 annual limit
NSOs are taxed twice, both at the time of exercise and the time of sale. ISOs are only taxed at the time of sale
ISOs may qualify for favorable tax treatment if the holder meets the requirements for a “Qualifying Disposition” (i.e. triggering one tax point at the time of sale instead of two)
AMT may come into play when exercising ISOs. AMT was put in place to prevent high-income taxpayers from paying too little tax

If you have questions specific to your situation that you’d like to discuss with us, we’re here for you. Give us a call when you’re ready to chat!