Tax differences between ISOs and NSOs
In the US, there are two types of compensatory : incentive stock options (often called ISOs) and non-qualified
- ISOs must be granted under an equity plan that has been approved by the company's 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 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 as of the date of grant. Read our article on best practices for by venture-backed companies.
The tax treatment to the holder differs between ISOs and NSOs. These differences are summarized in the table below.
Type | Tax Upon of * | Tax Upon Vesting | Tax Upon Exercise of | Tax Upon Sale of Shares |
---|---|---|---|---|
ISO | None | None | None** |
If shares are held at least (i) one year after exercise and (ii) two years from date, then the entire is taxed as . Otherwise, the option is taxed as if it were a NSO (but no income or employment tax withholding is required). |
NSO | None | None | The difference between (i) the fair market value of 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 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 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 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
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