ISO vs NSO - What's the Difference?

When it comes to stock options, startups often offer two types: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). Both serve as valuable tools for attracting and retaining talent, but they come with different tax implications and eligibility requirements.

Incentive Stock Options (ISOs)

ISOs are a type of stock option that can only be granted to employees. They qualify for preferential tax treatment under the United States Internal Revenue Code if certain conditions are met. The key benefits of ISOs include:

• Tax Advantages: ISOs are taxed via Alternative Minimum Tax (AMT) at exercise on the difference between their Strike Price and the Fair Market Value (FMV). When sold ISO gains are taxed on the difference between the strike price and sale price. To qualify for favorable capital gains tax treatment, ISO shares must be held for a specific period: at least two years from the grant date and at least one year from the exercise date.
  • NOTE: It might seem as though ISOs are double-taxed on the 'spread' (the difference between their Strike Price and Fair Market Value) at exercise. However, this is largely mitigated by AMT Tax Credits. These credits allow you to recoup the Alternative Minimum Tax (AMT) paid over time, effectively preventing double taxation. Importantly, if your ISOs are both exercised and sold within the same calendar year, this is considered an AMT Disqualifying Disposition, meaning no AMT is owed, only ordinary income tax on the sale.
• When Taxes are Due: AMT is not owed until you file taxes in April of the following year. Your company will send you a Tax Form 3921 in January showing the number of options, strike price, and FMV at time of exercise.
• Eligibility: Only employees can receive ISOs, and there is a $100,000 limit on the value of ISOs that can vest in any calendar year.‍
• Expiration: ISOs must be exercised within 90 days after an employee's last day of employment, otherwise they will expire.

Non-Qualified Stock Options (NSOs)

NSOs are more flexible than ISOs and can be granted to employees, directors, contractors, and other service providers. However, they do not qualify for the same tax benefits. Key points about NSOs include:

• Taxation: NSOs are taxed at the ordinary income tax rate upon exercise, based on the difference between the Strike Price and the Fair Market Value (FMV) of the shares. This amount is considered ordinary income and is subject to payroll taxes (Medicare, FICA, etc). When sold, NSO gains are taxed on the difference between the FMV at exercise and the sale price.
• When Taxes are Due: NSO taxes are typically withheld by the company at exercise, meaning your company will quote you for the cost of the strike price and taxes when you exercise your NSOs. It's important to remember that the amount withheld for taxes at exercise is an estimate. Your actual tax liability will be reconciled when you file your annual tax return, meaning you might owe more or receive a refund depending on the amount originally withheld.
• Flexibility: NSOs can be granted to a wider range of recipients, including non-employees, and there is no limit on the value of NSOs that can be granted in a year.
• Expiration: NSOs can be extended far beyond the typical 90-day period, allowing for exercise up to 10 years from their grant date.

Key Differences Between ISOs and NSOs

For employees of startups, understanding the differences between ISOs and NSOs can help you make informed decisions about your stock options:

1. Tax Treatment: ISOs are taxed at the lower Alternative Minimum Tax rate at exercise, whereas NSOs are taxed as ordinary income. If held for more than one year, both ISOs and NSOs are eligible for Long-Term Capital Gains. However, ISOs benefit from the lower LTCG rate on the entire profit from the strike price to the sale price, while NSOs can only achieve LTCG on the profits exceeding the FMV at the time of exercise.‍
2. Eligibility: Since ISOs can only be granted to employees, if you are an advisor or contractor you will only be able to receive NSOs.
   • If you leave a company or move to a part-time advisor role, the company can extend your 90 day ISO expiration deadline by flipping your ISOs to NSOs. This is called an NSO Extension, and it makes sense in many cases. While not always offered, NSO extensions are an employee-friendly perk that companies sometimes include (especially during broader layoffs) to soften the blow for departing employees, and it's a benefit you can often negotiate as you leave.

By understanding these differences, you can make informed decisions about your stock options and how they fit into your overall financial plan. Whether you receive ISOs or NSOs, both can be effective tools for building wealth and achieving your financial goals.

Written by Jordan Long, Marketing Lead at ESO Fund