Know Your Options: Comparing NQSOs And ISOs

Stock options became famous during the 1990s. It was then that many companies, even those beyond the tech industry, started to make broad-based option grants to rank-and-file employees, not just to executives, as a strategy to lure top talent. Even Seinfeld took notice. "So," Elaine says to Jerry and George in "The Money" (1997), "you understand how my Peterman stock options are gonna work?" While George (of course) feels only petty envy that she makes more than he does, it is a very good question. Before you exercise employee stock options and do any financial planning with them, you need to understand which type of options you have and their tax treatment.

While since the 1990s many companies have come to favor other equity grants, such as restricted stock units (RSUs) and performance shares, stock options remain a major form of equity compensation. Companies can grant two types: nonqualified stock options (NQSOs), the more common variety, and incentive stock options (ISOs), which offer some tax benefits but also raise the complexities of the alternative minimum tax (AMT).

Which Type Of Options Do You Have?

Before exploring the differences between NQSOs and ISOs, you must check your grant agreement and know which type of options you have. Many companies now have omnibus stock plans in which they are authorized to grant not only both types of stock options but also restricted stock, RSUs, performance shares, and stock appreciation rights (see, for example, Uber’s 2019 equity incentive plan). This is why you need to look at your specific grant to be sure of the award type you are receiving. If it’s still not clear to you, then ask the stock plan administrator or person at your company in charge of managing the employee stock option plan.

Nonqualified Stock Options

A nonqualified stock option (NQSO) is a type of stock option that does not qualify for special favorable tax treatment under the US Internal Revenue Code. Thus the word nonqualified applies to the tax treatment (not to eligibility or any other consideration). A few basic NQSO facts:

• NQSOs are the most common form of stock option and may be granted to employees, officers, directors, contractors, and consultants.
• Unexercised NQSOs can be transferred to others, such as upon divorce or gifting.
• There is no tax-code limit on the total number or value of NQSOs that can be granted.

You pay taxes when you exercise NQSOs. For tax purposes, the exercise spread is compensation income and is therefore reported on your IRS Form W-2 for the calendar year of exercise.

Example: Your NQSOs have an exercise price of $10 per share.

• You exercise them when the stock price is $12 per share.
• You have a $2 spread ($12 – $10) and thus $2 per share in ordinary income.
• You sell the stock at $16 per share, giving you $4 per share in capital gains ($16 –$12 tax basis). Whether the gain is long-term or short-term depends on your holding period after exercise.

When you exercise NQSOs, your company will withhold taxes: federal income tax, Social Security (up to the yearly limit), Medicare, and state taxes (if applicable). This withholding appears on your Form W-2 for that calendar year.

When you sell the shares, whether immediately at exercise or after a holding period, you need to report the stock sale on Form 8949 and Schedule D of your IRS Form 1040 tax return. For a detailed explanation of the tax rules, see the related sections of the Tax Center at myStockOptions.com.

Incentive Stock Options

Incentive stock options (ISOs) qualify for special tax treatment under the Internal Revenue Code and are not subject to Social Security, Medicare, or withholding taxes. However, to qualify they must meet criteria specified under the tax code:

• ISOs can be granted only to employees, not to directors, consultants, or contractors.
• There is a $100,000 limit on the aggregate grant value of ISOs that may first become exercisable (i.e. vest) in any calendar year.
• For an employee to retain the special ISO tax benefits after leaving the company, the ISOs must be exercised within three months after the date of employment termination (longer periods apply for disability and death).
• Unlike NQSOs, ISOs cannot be transferred to others (e.g. upon divorce or by gifting).

ISO Holding-Period Rules: Benefits But Risks

After you exercise ISOs, if you hold the acquired shares for at least two years from the date of grant and one year from the date of exercise, you incur favorable long-term capital gains tax (rather than ordinary income tax) on all appreciation over the exercise price. Meeting the holding-period requirements of an ISO can result in substantially lower taxes.

Example: Your exercise price is $10, i.e. the stock price at grant. You exercise when then market price is $15.

Holding period	Sale price	Taxable income
Less than 1 year from exercise*	$17	$5 ordinary income (reported on W-2) + $2 short-term gain
1+ year from exercise, 2+ years from grant	$17	$7 long-term capital gain, no ordinary income

*ISO taxation depends on: (1) when shares are sold; (2) the sale price relative to the exercise price and the market price at exercise.

However, the exercise spread on shares acquired from ISOs and held beyond the calendar year of exercise can subject you to the alternative minimum tax (AMT) and additional tax-return reporting (e.g. Form 6251). This can be problematic if you are hit with the AMT on paper gains but the company's stock price then plummets, leaving you with a big tax bill on income that has evaporated.

Alert: If you have been granted ISOs, you must understand how the AMT can affect you. You should do an AMT calculation whenever you exercise ISOs and hold the shares.

Summary

The table below, from myStockOptions.com, summarizes and compares selected major traits of NQSOs and ISOs.

Option type	Eligibility	Event that triggers taxes	Taxes	Withholding?	Tax at sale
NQSOs	Company employees, executives, directors, contractors, and consultants	Exercise	Ordinary income tax, Social Security, and Medicare on the exercise spread	Yes, at exercise	Capital gains tax
ISOs	Only company employees and executives	Sale, unless AMT incurred	Ordinary income tax, AMT, or none*	No	Capital gains tax*

*ISO taxation depends on: (1) when shares are sold; (2) the sale price relative to the exercise price and the market price at exercise.

Further Resources

For more knowledge and financial-planning insights on these different types of stock options, see the NQSO and ISO sections of myStockOptions.com. To discover what your gains would be after exercising options and selling the stock, try the site's Quick-Take Calculator for Stock Options and other tools. For potential differences in these grants at private companies, see the section Pre-IPO at myStockOptions.com.