How ISOs and NQSOs Differ

When you receive an offer that includes stock options, you're likely to see a single headline number. Your award agreement is more specific. It often opens with a one-page grant notice, which you typically sign or electronically accept, and that page labels your stock options by type: non-qualified stock options (NQSOs), incentive stock options (ISOs), or in some cases both. Beyond the label, the two are identical. Both carry a strike price, both follow a vesting schedule, and both are exercised the same way. They are the same instrument. What differs is how the tax code treats your gain, and above all, whether that gain is taxed when you exercise or when you sell.

In How Stock Options Work, we covered the steps that matter for every option:

• Vesting doesn't deliver anything. It only gives you the right to buy shares at the strike price. That's also why vesting isn't a tax event for either type of option, unlike an RSU, which is taxed when it vests.
• Exercising is the separate step where you act on that vested right and pay for the shares. Until you exercise, you don't own any shares, no matter how much your options have grown in value.

At exercise, two different amounts come into play, and they're easy to confuse:

• The exercise cost: the strike price times the number of shares you're buying. That's what you pay to own the shares.
• The spread: the difference between the strike price and what the shares are worth that day, multiplied by the number of shares. That's the gain built into your options at the moment you exercise, and it's the number tax rules care about.

Take the Fathcarr grant from How Stock Options Work: 20,000 options at a $10.00 strike price, vesting 5,000 a year. Say you choose to exercise your first 5,000 vested options. On the day you choose to exercise your options, Fathcarr's 409A valuation puts its common stock at $14.00, the value from What a 409A Valuation Tells You About Your Pre-IPO Stock Options.

Exercising 5,000 Fathcarr Options (sample)

Whether those options are ISOs or NQSOs, both numbers are the same. The type of option changes only one thing: when, and how, that $20,000 is taxed. With that refresher in place, here's why the two types exist and the differences you should keep in mind.

The NQSO is the default. Any stock option a company grants as pay is taxed under the general rules for compensation, and under those rules the spread counts as income the moment you exercise. "Non-qualified" simply means the option isn't set up to meet a special set of conditions.

The ISO is the exception. In 1981, Congress created the incentive stock option to encourage employees to own stock in the companies they work for, reviving an older tradition of tax-favored options that had been phased out in the 1970s. An ISO gets better treatment than the default:

• no regular income tax at exercise
• the chance to have everything above the strike price taxed at long-term capital gains rates when you sell

In exchange, it has to meet conditions the tax code sets:

• ISOs can only go to employees
• the options that can first be exercised in any one calendar year can't exceed $100,000 in value, measured at the stock's value on the grant date. Anything above that is treated as an NQSO, which is why some grants include both types.
• keeping the tax advantage also requires holding the shares for set periods before you sell, covered below.

The two types also divide a tax advantage differently between you and your company.

That tradeoff helps explain why companies use each where they do:

• ISOs suit early-stage companies. A company that isn't yet paying income tax, typically because it is losing money, gets little immediate value from a tax deduction (losses can carry forward, so it isn't worth nothing). Giving up the deduction costs it little and can make the offer more attractive to recruits.
• NQSOs suit profitable companies. A profitable company with taxable income gets real value from the deduction. NQSOs are also more flexible: no employee-only rule and no $100,000 cap.

The two types differ in when the spread is taxed and, if you meet the ISO's conditions, in how it's taxed.

With an NQSO, the spread is taxed at exercise. The $20,000 spread from the Fathcarr example earlier in this module is ordinary income in the year you exercise, and Fathcarr generally has to apply tax withholding to it, just as it would to your salary. That's true even though you can't readily sell private company shares to cover the bill. Any change in value after exercise is taxed later, as a capital gain, when you sell.

With an ISO, the spread is generally taxed at sale instead. Exercising doesn't create regular income tax, so the $20,000 spread isn't taxed that year, though it can count toward the alternative minimum tax (AMT). The tax question is settled when you sell, and the answer depends on how long you held the shares. Hold them at least two years from the grant date and one year from exercise, and the sale is a qualifying disposition: everything above the strike price, including that $20,000, is taxed as long-term capital gains. Sell earlier, and it's a disqualifying disposition: the spread is taxed as ordinary income after all, much as it would have been with an NQSO.

To see both differences at once, follow a single one of those 5,000 shares through to a sale at $30:

One Fathcarr Share, Two Tax Treatments (sample)

*Long-term if held more than one year after exercise. The ISO's $4 spread isn't subject to regular income tax at exercise but may count toward the alternative minimum tax.

Neither type is better in every situation. With an NQSO, how the spread is taxed is fixed when you exercise. With an ISO, it isn't settled until you sell, and the better result requires holding the shares through both holding periods, which at a private company can mean holding shares you can't easily sell while their value moves.

ISOs and NQSOs are the same instrument, taxed differently. Here are three takeaways for you to consider:

• Know which type you hold, and whether you hold both. Check the grant notice. The label determines everything else.
• For NQSOs, exercising is a tax event, so plan for cash. You owe tax on the spread the year you exercise, and your employer withholds on it, whether or not you sell. At a private company you usually can't sell shares to cover it, so exercising takes cash for both the exercise cost and the tax.
• For ISOs, the advantage is conditional and has costs. No regular tax at exercise doesn't mean no tax: AMT can apply. The capital gains benefit only comes if you hold the shares through both holding periods, which at a private company means owning illiquid shares that can lose value. Selling before the holding periods end means the spread is taxed as ordinary income after all.

Either way, it's worth talking to a tax advisor before you decide when to exercise, especially if you hold ISOs.