Equity Incentives

Tax differences between ISOs and NSOs


In the US, there are two types of compensatory stock options: incentive stock options (often called ISOs) and non-qualified stock options (often called NSOs). Companies can ISOs or NSOs to their employees. However, they cannot grant ISOs to non-employees. Therefore, options granted to contractors/consultants, advisors and non-employee directors - can only be NSOs. Other requirements of ISOs include:

  • ISOs must be granted under an equity plan that has been approved by the company's stockholders and that has a limit on the number of shares that may be issued under the plan;
  • ISOs must have an per share that is no less than the fair market value per share of the underlying stock as of the date of grant (110% if the person is a 10% shareholder);
  • ISOs must have a term of no more than 10 years (5 years if the person is a 10% shareholder);
  • The value of the shares that may vest in any year (calculated using the date fair market value) may not exceed $100,000; and
  • ISOs must be nontransferable.

NSOs don't have the same restrictions. However, to avoid significant adverse tax consequences to the optionholder it is generally the case that even NSOs must have an per share that is at least equal to the fair market value per share of the underlying stock as of the date of grant. Read our article on best practices for option by venture-backed companies.

The tax treatment to the option holder differs between ISOs and NSOs. These differences are summarized in the table below.

Option TypeTax Upon of Option*Tax Upon VestingTax Upon Exercise of OptionTax Upon Sale of Shares
ISONoneNoneNone**

If shares are held at least (i) one year after exercise and (ii) two years from date, then the entire spread is taxed as .

Otherwise, the option is taxed as if it were a NSO (but no income or employment tax withholding is required).

NSONoneNoneThe difference between (i) the fair market value of stock at time of exercise minus (ii) the is taxed as ordinary income and is subject to income and employment tax withholding.The difference between (i) the fair market value of stock at time of exercise minus (ii) the is taxed as ordinary income and is subject to income and employment tax withholding

The difference between (i) the sale price minus (ii) the fair market value of the stock at the time of exercise is taxed as .

*Assumes that the per share is equal to or greater than the fair market value per share on the date of grant .

**The difference between (i) the fair market value of stock at time of exercise minus (ii) the is included in the person's Alternative Minimum Tax (AMT) calculation.

While there are potential tax advantages to ISOs, it is frequently the case that people sell their optionshares very shortly after exercising the option. For example, option holders in public companies often sell the shares right after exercise in order to lock in the gain or to help cover the and AMT arising on the ISO exercise. Further, option holders in both private and public companies may be required to exercise their options when the company is acquired, and the shares are then sold or exchanged in connection with the acquisition. As a result, most holders of ISOs won't ultimately benefit from the tax advantages of having ISOs, because these sales are treated as "disqualifying dispositions" thereby causing the option to be treated as a NSO. Despite this, most private companies nevertheless grant employees ISOs instead of NSOs because of the potential tax benefits.

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