Overview of Stock Options

Stock options are contracts that give a third party the right to purchase shares of a company’s stock at a predetermined price (known as the exercise price), for a certain period of time. Stock options generally come in two forms Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs).

Companies frequently use stock options as part of an overall equity compensation program designed to attract, retain, and incentivize employees and contractors. Understanding the nuances of stock options—and how to structure stock option plans—is an important part of building a competitive compensation strategy, particularly for companies seeking to reward performance while preserving cash. Additionally, by giving recipients the opportunity to share in the future growth of the company, stock options can align the interests of the recipients with the long-term success of the business.

Stock options are particularly common among startup and growth-stage companies that may prefer to offer equity participation in addition to, or in lieu of, higher cash compensation. However, established companies also use stock options as part of executive compensation and long-term incentive plans.

Typically, stock options vest over time according to a schedule set forth in the company’s equity incentive plan or award agreement. These schedules are designed to encourage continued service with the company and are usually based on time, performance milestones, or a combination of both.

Key Differences Between ISOs and NSOs

Tax Treatment: How are ISOs and NSOs taxed?

ISOs:

• ISOs are generally eligible for favorable tax treatment. When exercised, no regular income tax is due on the spread between the fair market value of the underlying stock and the strike price; instead, taxes are applied when the underlying stock is sold. Provided stock acquired from the exercise of an ISO is held for both two years from the date the ISO was granted and one year after exercise, then all of the gain on sale is taxed at preferential long term capital gain rates. If stock acquired through the exercise of an ISO is sold and fails to satisfy either time period, the stock loses its ISO status, the gain is bifurcated, and subject to tax at least in part at ordinary income rates.
• Contrary to the general rule described above, the spread on the exercise of an ISO is included when determining the option recipient’s Alternative Minimum Tax (AMT) liability, if any. AMT liabilities are often an unpleasant surprise and can add cost and complexity to tax filings. That being said, AMT exposure can sometimes be mitigated if the holder is strategic about exercising and meeting holding timelines.

NSOs:

• The spread between the fair market value of the underlying stock and the NSO’s strike price is taxed as ordinary income at the time of exercise. There are no special tax benefits when the underlying stock is sold; gains are taxed at the applicable capital gains rates depending on the holding period.
• Exercising NSOs will not have AMT impact at the time of exercise, as any gain from the exercise is treated as regular income.

Eligibility: Who are eligible to receive ISOs and NSOs?

ISOs:

• Only employees (not independent contractors or board members) can receive ISOs. There are also restrictions on the maximum value of ISOs that can be granted, which is currently $100,000 per employee per year (based on the exercise price).

NSOs:

• NSOs can be granted to a broader group, including employees, contractors, and board members, without a cap on the value.

Plan Requirements: What is required to issue ISOs and NSOs?

ISOs:

• ISOs must be offered under a plan that is approved by shareholders and must comply with specific IRS regulations, such as limits on the maximum options granted to any individual, and exercise price (must not be less than the FMV of the underlying shares at the time of grant).

NSOs:

• NSOs do not have to meet these stringent IRS requirements and can be structured with more flexibility.

Conclusion

ISOs are typically more favorable for employees due to potential tax advantages, but they come with stricter eligibility and regulatory requirements. NSOs are more versatile and easier to distribute but come with immediate tax liabilities upon exercise.

For companies evaluating how to structure stock option plans, understanding when companies should use ISOs vs NSOs—and the tax implications of ISOs vs NSOs—is critical to designing an effective equity compensation strategy. Similarly, understanding these differences is crucial for the recipient as they evaluate their potential stock options grants and make decisions regarding exercise.

Companies considering implementing or revising an equity compensation program should work closely with legal and tax advisors to ensure that stock option plans are properly structured, compliant with applicable laws and regulations, and aligned with the company’s broader compensation and retention strategies. A properly designed option plan will help companies deploy valuable compensation plans and align interest, while at the same time maintaining appropriate governance and ownership control. Likewise, individuals receiving stock options should seek professional guidance to understand the financial and tax implications of exercising and holding their options.