Differences Between Incentive Stock Options and Nonqualified Stock Options

One of the questions executives of emerging companies face when issuing stock options is what type of option to issue. There are two types of stock options: incentive stock options (also known as statutory stock options) (ISOs) and non-qualified stock options (also called non-statutory stock options) (NSOs).

Both ISOs and NSOs give the option holder a right to purchase shares of stock at the stated exercise price that is of value only if the shares of underlying stock subject to the option increase in value, and it is common for a stock option plan to permit both types of grants — but there are important differences. As such, it is vital for companies and service providers to understand the differences between ISOs and NSOs.

As you will see below, there are some significant potential tax benefits that ISOs have over NSOs, but qualifying for those benefits can be a challenge, and many recipients of ISOs never see those benefits.

Primary Differences Between ISOs and NSOs

	ISO	NSO
Limits on eligible recipients?	Only common-law employees, and the recipient must be a person. ISOs can't be issued to entities	Both employees and independent contractors (including non-employee directors) are eligible
Are the options taxable to the option recipient when granted?	No – if the exercise (strike) price is at least equal to the fair market value (FMV)* as of grant date

Taxable for AMT, but not income or employment tax purposes

The difference between FMV at time of exercise and exercise price (the "spread") is not subject to ordinary income tax or employment taxes
The spread is taxable for AMT purposes. This can result in significant tax liabilities in connection with an IPO

Taxable for income and employment tax purposes, but not AMT purposes

The spread is subject to ordinary income tax and employment taxes, and subject to required income tax and employment tax withholding

The spread is not taxable for AMT purposes

The exercise price must be at least 110% of FMV as of grant date, and
The maximum term of the option is five years

Entirely long term capital gain if two holding periods are met, which requires that the stock is held for both at least 2 years after the option is granted and at least 1 year after the option is exercised
If both holding periods are not satisfied, then taxed as NSO (spread value at exercise is taxed as ordinary income, and any subsequent gain is treated as capital gain)

Tax rules also impose the following requirements on ISOs, but not NSOs:

ISOs must be issued pursuant to a written plan that specifies the maximum aggregate number of shares that may be issued under the plan through ISOs;
The option plan must be adopted by the company's shareholders within 12 months before or after the plan is adopted by the board of directors; and
Any amendment that increases the number of shares that may be subject to ISO grants must be approved by the shareholders.

Although ISOs can provide a favorable tax result—no ordinary income or employment taxes at ISO exercise if the holding periods are met—the company and the employee must be prepared to comply with more burdensome restrictions in order to achieve this result. In addition, the full tax benefits of ISOs are only realized if an employee exercises the ISO and holds the stock for more than a year prior to a company sale or other liquidity event.

In our experience, employees of privately held companies typically do not exercise their options prior to a sale of the company or other liquidity event, and so they do not receive the potential tax benefit from ISOs.