What Is The Difference Between An ISO And An NSO?


For many California business employers, stock options are a key part of their compensation packages.  In some instances, employee stock options are the main form of compensation, while in others, it is a small portion of the overall compensation package.  But how do new corporations and small business owners initiate and successfully manage these business transactions?  What do each of these business transactions even mean? California business owners Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs) are two different forms of stock options that a corporation can give and qualification refers to eligibility for special tax treatment.  For example, ISO stock options provide a tax break that NSOs do not.

What Is The Difference?

An ISO is a special form of stock option that is given special treatment under the tax code: it is not subject to income tax, based on the fact that it is an incentive to the employee.  Because of this, ISOs can only be issued to employees of a company, a parent company, or a subsidiary.

In contrast, NSOs are subject to income tax, and can therefore be granted to anyone (employees, consultants, directors, etc.).

Creating and managing stocks, whether ISO or NSO, can be a very tedious process and can have a large impact on the business itself.  Capital gains tax liability applies to any stock or security obtained in the exercise of a stock option, regardless of whether it was an ISO or NSO.  It is important to discuss the options with an experienced California corporate attorney who can advise on the best options for each specific corporation.

Why Do Employers Choose NSOs?

There are many reasons an employer may choose to issue NSOs instead of ISOs in their compensation packages.  Among the most common are:

  • The employer only has to issue one type of stock option for all employees, contractors, directors, and others entitled to it.
  • NSO taxes are determined by the employee, whereas ISOs require the employer to issue an IRS Form 3922 in order for the employee to exempt the stock option from his or her taxable income.
  • In general, ISOs are less flexible and more difficult to administer.
  • The spread on the exercise of NSOs is deductible to the employer (as income paid to the employee).
  • Many employees do not access the tax benefits of an ISO. This is because the underlying securities received when a stock option is exercised must be held until the later of one year after exercise or two years after the ISO was granted.  If these holding periods are not met, the ISO becomes disqualified, and it is treated as an NSO.  There is also a $100,000 limit on the amount of ISO that can be exercised in a calendar year.  If the stock option is for more than $100,000 it is split into both ISO and NSO for tax liability purposes.

Call Today to Speak with a California Corporate Attorney

If you have questions about stock options, compensation packages, or other business matters, the experienced corporate law attorneys at Startup Company Counsel are here to help.  If you hold stock options or restricted shares in a private company, knowing and understanding the differences between an ISO and NSO and how it affects you are very important.  Call (408) 441-7555, or use our online contact form to schedule your consultation with a California corporate attorney today.

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