Differences between Incentive Stock Options (ISOs) and Nonstatutory Stock Options (NSOs)

September 1, 2011

Here is an outline of some of the principal differences between two different types of compensatory stock options: incentive stock options (ISOs) and nonstatutory stock options (NSOs). This outline is intended as a starting point, but does not address all of the tax aspects of stock options or all of the differences between ISOs and NSOs. This outline is based on U.S. federal tax treatment and does not address any differences under state, local or foreign tax law.

  • ISOs may only be granted to employees; NSOs may be granted to employees, consultants and advisors.
  • The exercise price of an ISO or NSO must be at least 100% of the fair market value of the underlying shares on the date the option is granted.  For ISOs granted to an individual who owns more than 10% of the company, the exercise price must be at least 110% of the fair market value of the shares on the date of grant, and the option term cannot exceed 5 years.
  • In general, neither ISOs nor NSOs are taxable at the time of grant.
  • Ordinary income tax does not apply at the time of exercise of an ISO, but alternative minimum tax (AMT) may apply, especially for executives.  Upon sale of ISO shares, tax is based on the difference between the sale price and the original exercise price.  If the holding periods noted below have been satisfied, the entire amount of gain is eligible for long-term capital gain treatment.
  • Ordinary income tax applies at the time of exercise of an NSO, based on the difference between the exercise price and the fair market value of the shares at the time of exercise.  The taxable compensation upon exercise then effectively increases the tax basis of the shares.  Upon sale of NSO shares, tax is based on the difference between the sale price and the fair market value on the date of exercise, and the amount of this difference may be eligible for capital gain treatment (depending on how long the shares are held).
  • The first $100,000 in aggregate exercise price for options vesting during any calendar year is eligible for ISO treatment.  Options in excess of this amount are treated as NSOs from the date of grant.  As an example, for options priced at $0.10 per share, this means that up to 1,000,000 shares can vest in a calendar year and be treated as ISOs.  Any additional shares vesting in that calendar year, even if originally designated as ISOs, will be considered NSOs from the date of grant.  Note that in the calendar year of an employee’s first anniversary under a typical 4-year vesting schedule, vesting will include the first 25% of the option shares plus monthly vesting between the anniversary date and the end of the year (up to an additional 22.9% of the option shares).
  • ISOs that exceed the $100,000 limitation in any calendar year must be tracked with separate ISO and NSO components (and are sometimes issued in separate stock option agreements, one designated as an ISO and the other as an NSO).
  • In order to retain ISO treatment, ISO shares must be held for at least 12 months following exercise of the option (and at least 24 months from the date of option grant).  If shares are sold before the completion of either of these holding periods, the ISO is “disqualified” and becomes an NSO for most purposes.  At that point, the company is generally required to treat the option as an NSO for accounting and withholding purposes.
  • Except in cases of termination of employment, employees often wait to exercise (and to pay the purchase price) until there is a market for the shares (such as following an initial public offering (IPO) or in connection with a merger) and then sell shares soon after exercise resulting in disqualification.  A large number of ISOs are ultimately disqualified for this reason.
  • The company may generally take a tax deduction for the compensation deemed paid upon exercise of an NSO.  Some companies prefer to grant NSOs for this reason.
  • Employees may prefer ISOs due to the ability to defer ordinary income tax until the sale of the shares and the potential for a lower tax rate on the component of gain between grant and exercise (if holding periods are satisfied).  Note that alternative minimum tax, if applicable, is not deferred for the exercise of an ISO.
  • The company should consult with its outside accountants regarding the various tax, accounting, withholding and financial statement differences between ISOs, disqualified ISOs, and NSOs.
  • Individual option recipients should always consult with their personal tax advisors because of differences in individual tax situations.
  • For some of the best guidance on the tax treatment and other key aspects of stock options, I highly recommend The Stock Options Book by Alisa J. Baker published by the National Center for Employee Ownership.

Choice of Entity for a Startup Company

June 1, 2011

The choice of legal entity for your business is a critical decision for any startup company.  If you want to attract venture capital investment, you need to form a corporation, most likely under Delaware law, for a number of reasons.  Venture capital funds are generally unable to invest in an LLC, LP or other so-called “pass-through” entity because of tax issues (an LLC can generate taxable gain or loss to its members from day one, and venture funds are usually prohibited from receiving such gain or loss until their investment is liquidated upon sale).  Many venture capital investors (through their lawyers) encourage startup formation under Delaware law because Delaware has a very well-developed body of corporate law and has a specialized court to hear business cases.  Investment funds also like to use their existing investment documents which may be tailored to Delaware law.  Some venture capital investors, however, are perfectly comfortable investing in a California corporation.

Angel investors (typically wealthy individuals) are sometimes willing to invest in an LLC, especially if the investor will become an active partner in the business and if pass-through tax treatment is advantageous for the investor.  In my experience, though, you lose many of your potential investors if you are organized as an LLC.  LLCs are well-suited for many consulting and other service businesses, and for holding real estate or patents, but corporations dominate the world of startups.

In addition, startup companies generally use stock options as a major form of compensation for employees and consultants.  Only a corporation can issue true stock options.  LLCs can issue other forms of equity incentives to employees, such as “profits” interests, but there are substantial tax and accounting complications due to the fact that most LLCs are taxed as partnerships.  For example, if an employee of an LLC receives an equity interest in the company, the recipient may have to be treated for tax purposes as a “partner” (subject to self-employment tax) rather than an “employee” (whose wages are reported on Form W‑2).  An employee of a corporation who receives stock or stock options will generally continue to be treated as an “employee” for tax purposes. Finally, because of partnership tax treatment, an LLC will often need to adjust the capital accounts of existing LLC members in order to reflect the current fair market value of the company’s assets each time a new LLC interest is issued (potentially incurring additional accounting and valuation expenses).