Stock options are key tools startups use to recruit and retain employees, advisors, contractors, and more. They give startup team members a piece of the upside in the company, which is a critical form of compensation for startups that can rarely pay market salaries to their team.
There are two core types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). In this post we’ll be looking at the differences between ISOs and NSOs, as well as why startups might grant one versus the other in different scenarios.
Eligibility
The place to start is with eligibility. Only current employees are eligible to receive ISOs. This restriction on eligibility for ISOs makes it easy for startups when they’re considering an option grant to a non-employee: it will have to be an NSO.
Should Startups Grant ISOs or NSOs?
As we now know, if a startup is granting options to a non-employee, the answer to this is easy: only NSOs can be granted. If a startup is granting options to an employee, though, the choice may be more complicated.
The main reason why a startup would grant ISOs to an employee is that there is a potential tax benefit to the recipient of ISOs. However, this potential tax benefit comes with a host of requirements that must be met. There can also be hidden risks with ISOs. To unpack this, we’ll need to get familiar with taxes in this setting.
Taxes on Stock Options
Option recipients generally want to pay the lowest rate of taxes on their options. This means paying long-term capital gains rates, rather than ordinary income rates. Keeping this in mind will help as we get into the tax weeds.
There are four points at which taxes on stock options need to be considered: (1) when granted, (2) when vesting, (3) when exercised, and (4) when sold.
When Granted
Options won’t be taxed at the time they are granted so long as the exercise price is equal to the fair market value (FMV) at the time of grant. The way to ensure this is to tie the exercise price to a valid 409A Valuation. Failure to comply with Section 409A could result in significant taxes and penalties, especially for the recipient of the stock options. So long as startups are following best practices here, there shouldn’t be any taxes on options when they’re granted. This is true for both ISOs and NSOs.
Options similarly won’t be taxed when they vest so long as the exercise price is equal to the FMV at the time of grant. This is again true for both ISOs and NSOs.
When Exercised
Exercise is the first point at which ISOs hold a potential tax benefit over NSOs. Specifically, ISOs are not subject to ordinary income, capital gains, or employment taxes at the time of exercise.
Example: If Tom is granted an ISO to purchase 100 shares at a $1 exercise price, and if he exercises his ISO when the FMV of the shares is $4 per share, he will not owe any taxes at the time of exercise.
In contrast, for NSOs, the difference between the exercise price and the FMV at the time of exercise (the “spread”) is taxed as ordinary income.
Example: Assume that Tom was granted an NSO instead of an ISO. In that case, Tom would owe ordinary income tax on $3/share, which is the spread between the exercise price ($1/share) and the FMV at the time of exercise ($4/share).
At first glance, it would seem that ISOs have the clear advantage here. However, that’s not the whole story. The Alternative Minimum Tax ("AMT") also has to be considered for ISOs.
AMT is a special type of income tax with its own rules. It’s usually relevant to higher income earners–it’s also relevant when exercising ISOs. For ISOs, the spread between the purchase price and the exercise price is subject to AMT. As a result, for some optionees in certain situations, ISOs may still have undesirable tax consequences at the time of exercising. High income optionees in particular should consult with tax advisors to determine potential AMT exposure.
When Sold
Sale is the second point at which ISOs hold a potential tax benefit over NSOs. Specifically, ISOs have the potential for more gains to be subject to preferential long-term capital gains tax rates than NSOs.
Example: Tom and Tina are both granted an option to purchase 100 shares at a $1 exercise price. Tina is an employee and is granted an ISO, while Tom is a contractor and is granted an NSO. Tina and Tom both exercise their option when the FMV of the shares is $5. Several years later, they both sell their shares for $7 per share.
Assuming Tina met both holding periods (more on this below), Tina would pay long-term capital gains rates on the difference between her exercise price ($1/share) and the sale price ($7/share). The graphic below illustrates this.
Tom, on the other hand, assuming he met the holding period, would pay long-term capital gains rates on the difference between the FMV of the shares when he exercised ($5/share) and the sale price ($7/share)--as we know from the previous section, Tom would have already paid ordinary income tax on the spread between the exercise price ($1/share) and the FMV of the shares when he exercised ($5/share). The graphic below illustrates this.
These examples show the significant potential tax benefit of ISOs over NSOs when seeking to maximize exposure to capital gains tax rates and minimize exposure to ordinary income rates.
However, in order to realize this benefit, ISO recipients must meet two holding periods: (1) the shares have to be held for 1 year past exercise, and (2) the shares have to be held for 2 years past the grant date.
For NSO grants, on the other hand, the optionee only needs to hold the shares for 1 year past exercise for long term capital gains rates to apply.
Below is a table to help illustrate some of the key tax differences between ISOs and NSOs.
ISOs
NSOs
Tax at Grant
No tax (if granted at FMV)
No tax (if granted at FMV)
Tax at Vesting
No tax (if granted at FMV)
No tax (if granted at FMV)
Tax at Exercise
No ordinary income, capital gains, or employment tax. However, the difference between the FMV and exercise price is treated as income for purposes of calculating AMT.
The spread between FMV and exercise price is taxed as ordinary income.
Tax at Sale
Sale price less exercise price taxed as long-term capital gains, so long as held for 1 year past exercise and 2 years past grant date.
Sale price less FMV at exercise taxed as long-term capital gains if held for 1 year past exercise.
Additional Requirements for ISOs
There are real potential tax benefits for ISOs, though eligibility and holding period requirements can make it challenging for these benefits to be realized. In fact, there are a number of additional requirements for ISOs even beyond eligibility and holding periods, including the following:
ISOs must be exercised within three months following the optionee’s termination of employment.
ISOs must be exercised within 10 years of the date they are granted.
ISOs are subject to the “$100k Rule,” which prevents employees from treating more than $100,000 worth of exercisable options as ISOs in a calendar year. Any options exercisable above this $100,000 limit will be re-characterized as NSOs and taxed at the date of exercise.
ISOs can only be granted by a company taxed as a corporation.
ISOs are only transferable upon the death of the optionee.
ISOs granted to shareholders that own more than 10% of the company must have an exercise price that is at least 110% of the FMV as of the grant date, and the maximum term of the option is five years.
So... Should a Startup Grant ISOs or NSOs?
As we’ve seen, ISOs have the potential to confer real tax benefits on employees. However, we’ve also seen that both the company and the optionee have to meet many requirements in order to obtain these benefits. In practice, companies and optionees often don’t meet these requirements, particularly the holding periods necessary for optionees to realize the full tax benefits.
With that said, the only honest answer to the question of whether a company should grant ISOs or NSOS is that it depends–on the company, the specific situation of the optionee, and a number of other factors that have to be considered in order to provide a meaningful answer to the question. This is where experienced legal counsel can prove invaluable to startups navigating the complex intersection of equity compensation, tax, and securities laws.
Bonus Content: EORs and Early Exercise
There are two particular scenarios where issuing NSOs to employees usually makes sense: EOR employees and employees who plan to early exercise.
EOR Employees
In a remote work environment where talent is distributed around the globe, employer of record (EOR) services are often used by startups to hire employees in other countries. In this arrangement, the EOR is the direct employer but the employee provides services to the startup that’s retained the EOR.
Given that the employee is an employee of the EOR, rather than the startup, the startup cannot issue ISOs to the employee. So, for a startup granting equity to a service provider employed by an EOR, it must issue NSOs.
Early Exercise
Startups may in certain circumstances permit an option recipient to “early exercise” their option, meaning the optionee can purchase the option shares prior to their vesting. Where an employee plans to early exercise soon after the time the option is granted and the exercise price and FMV of stock at the time of exercise is the same or very close to the same (i.e., little if any spread subject to ordinary income tax), it usually makes sense to grant NSOs to the employee. That leaves any subsequent gains subject only to capital gains tax rates–and the employee will only have to hold the shares for 1 year in order to get long term capital gains rates.
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