The Difference: ISOs vs. NSOs Equity Compensation

Incentive stock options (ISOs) and non-qualified stock options (NSOs) are two common types of equity compensation. Tech companies in the United States often give them to key employees.

Both ISOs and NSOs provide executives with an opportunity to purchase company stock at a predetermined price. But there are several differences between the two in terms of eligibility, taxation, and other important factors.

In this discussion, we explore the differences between ISOs and NSOs and how they affect executives at technology companies in the US.

Eligibility

ISOs are typically reserved for key employees and executives. NSOs can be granted to a broader range of employees, including contractors and consultants. To be eligible for ISOs, an employee must be a US taxpayer and work continuously for the company or its subsidiary for at least one year from the date of grant. On the other hand, there are no specific eligibility requirements for NSOs.

Granting

ISOs can only be granted by the board of directors or a committee appointed by the board, such as a compensation committee. The grant price for ISOs is set at the fair market value of the company’s stock on the date of the grant. In contrast, NSOs can be granted by any individual or entity that has the authority to grant options, and the grant price is not required to be at the fair market value of the stock.

Vesting

ISOs generally have a multi-year vesting schedule. For example, a standard four-year vesting schedule, with a one-year cliff, meaning that the executive must remain employed with the company for at least one year before any ISOs can be exercised. After the first year, the options vest monthly over the remaining three years. NSOs can have any vesting schedule that the company chooses, including immediate vesting.

Holding Period and Value Restrictions

ISOs require a minimum holding period of two years from the date of grant and one year from the date of exercise to qualify for long-term capital gains tax treatment. If the shares are sold before these holding periods are met, the difference between the sale price and the exercise price is treated as ordinary income and subject to higher tax rates. Additionally, there is a limit on the value of ISOs that can be exercised in any one year, which is currently $100,000.

NSOs do not have any holding requirements, and the executive can sell the shares at any time after exercising the options. There is also no limit on the value of NSOs that can be exercised in any one year.

Tax at Exercise

When an executive exercises ISOs, they do not have to pay any taxes at that time. Instead, they receive a tax benefit in the form of a lower tax rate on the eventual sale of the shares, as long as they hold the shares for at least two years from the date of grant and one year from the date of exercise.

When an executive exercises NSOs, the difference between the fair market value of the shares at the time of exercise and the grant price is treated as ordinary income and subject to income tax and payroll tax withholding.

Tax at Sale

When the executive sells the shares acquired through ISOs after the required holding periods, the difference between the sale price and the exercise price is taxed at the long-term capital gains tax rate, which is typically lower than the ordinary income tax rate.

When the executive sells the shares acquired through NSOs, the difference between the sale price and the fair market value at the time of exercise is subject to capital gains tax or ordinary income tax, depending on how long the shares were held.

Other Differences

ISOs and NSOs also differ in terms of their impact on a company’s financial statements. ISOs are not considered a compensation expense and therefore do not reduce a company’s net income. In contrast, NSOs are considered a compensation expense and reduce a company’s net income.

Resources:

More on tax benefits of ISOs: Intuit – Incentive Stock Options

More on tax implications of NSOs: Intuit – Nonqualified Stock Options