If you’ve read Employee Stock Options Part 1, you’ll already understand stock options, the exercise price, the exercise period, and the vesting period. Now we’re going to focus on the differences between the two most common types of options – NSOs and ISOs – and how they can impact your choices to exercise and sell options.
What is NSO?
NSO, or sometimes NQSO, stands for non-qualified stock options. These types of options are typically offered to all startup employees at all levels. NSOs can also be offered to non-employees, consultants, and directors. The IRS considers NSOs as part of your compensation and charges you income tax on the stocks (we’ll go into more detail below).
What is ISO?
ISO stands for incentive stock options. These types of options can’t be offered to non-employees, and they can’t be transferred to family members or friends.
ISOs are not taxed at the same rate as your regular income, as long as you follow certain IRS rules (we’ll discuss these rules below).
What are the main differences between ISOs and NSOs?
Both NSOs and ISOs are full stock options. When you exercise either an ISO or an NSO, you get equal say in the future of the company and an equal share of the profits, regardless of which type of option you exercised.
The essential difference between NSOs and ISOs lies in the way that they are treated by the IRS.
- NSOs are taxed at your regular income tax rate.
- ISOs are taxed at a preferential capital gains rate.
In order to qualify for preferential tax treatment, ISOs need to meet certain requirements which do not apply to NSOs:
- The option price for ISOs must be the same as the fair market value of the stock on the grant date. The option price for NSOs can be lower than the fair market value.
- ISOs can only be granted to and exercised by startup employees. NSOs can be granted to and exercised by non-employees, including family members and interested parties.
- Each employee can only vest up to $100,000 worth of ISOs each calendar year. The value of the ISOs is determined by the aggregate fair market value on the grant date. If you vest more than $100,000 in ISOs in a single calendar year, all stocks worth over that limit are treated like NSOs. There is no limit to how many NSOs you can vest each year.
- ISOs are not transferable except through the death of the employee. NSOs can be transferred to family members or a family trust, according to the rules established by your board of directors.
- You have to exercise your ISOs within 10 years of the grant date, or three months of the termination of your employment. You have to exercise your NSOs within the exercise period that is fixed by the board of directors, which could be shorter or longer than the 10-year period for ISOs.
When do you have to pay tax on NSOs?
1. When you exercise your options
Because NSOs are considered part of your compensation package as an employee, the IRS taxes them at the same rate as all the rest of your income.
Let’s continue our example from Part 1. Just to remind you, you’re an employee at FuzzyBear Inc. You’ve been awarded 8,000 NSOs, with an exercise price of $0.50, and a four-year vesting period.
Here’s a step-by-step guide to the tax you might typically have to pay:
- The grant date is January 2017. You’re awarded 8,000 NSOs. You don’t owe any tax.
- In January 2019, you want to exercise your NSOs. 4,000 of them have now vested. You pay $2,000, and now you own 4,000 shares in FuzzyBear Inc. Congratulations!
- It gets better. In the last two years, FuzzyBear Inc.’s stock has shot up to $4 per share. You spent $2,000, and now you own stock worth $16,000!
- Exercising your NSOs is a taxable event. The IRS checks the spread (the difference between the current market value of your 4,000 shares and the amount you paid for them), which is $14,000 in this case. The IRS charges your regular income tax rate of 32% on $14,000 worth of stocks, so you’ll have to pay $4,480 in income tax.
Note: There are ways to reduce the amount of income tax that is payable on your NSOs. We discuss how to minimize this tax payment in an upcoming post.
2. When you sell or trade your stocks
If the value of your stocks has gone up even more by the time you sell or trade your stocks, the IRS charges you capital gains tax on the profit you’ve made.
- If you sell or trade-in your stocks within one year of exercising, you’ll be charged short-term capital gains tax.
- If you hold on to them for at least one year from the date of exercise, you’ll be charged long-term capital gains tax. This is usually much lower than the short-term capital gains rate.
As a result, it’s usually best to hold them for at least 12 months. However, there can be good reasons to sell early that override tax considerations, such as the need to access urgent cash, if you anticipate a large drop in value in the near future, or if you have no choice because the company is exiting.
When is the best time to exercise NSO?
Choosing the best time to exercise your NSOs is tricky. We’ll discuss this in detail in a future post. Here are some points to consider when deciding when to exercise your NSOs:
- What is their current market value? (Don’t exercise if it is below your option price.)
- How much further do you think the stocks may rise?
- How urgently do you need cash now?
- What is your level of risk tolerance?
- Do you expect your income tax bracket to rise or fall in the near future?
- How many shares have vested?
- How many years remain until your NSOs expire?
What are your benefits as an ISO holder?
The chief benefit of being awarded ISOs instead of NSOs is that you’ll often be able to avoid having to pay any income tax on your ISOs and only pay long-term capital gains tax. You might need to pay Alternative Minimum Tax (AMT) contributions, which we’ll discuss in-depth in another employee stock options post.
What is the tax reduction for ISO?
Continuing our FuzzyBear Inc. example, here’s a very brief guide to the tax you’d typically have to pay if you were awarded 8,000 ISOs, with an exercise price of $0.50 and a four-year vesting period. (We’ll discuss how to reduce your taxes for ISOs more deeply in another employee stock options guide post.)
- You are granted 8,000 ISOs in January 2017. You don’t have to pay any tax.
- In January 2019, you exercise 4,000 NSOs that have vested to date. Current market value is $4 per stock, but you buy them at the exercise price of $0.50 each. Usually, you won’t have to pay any tax at this time.
- Congratulations! You now own stock worth $16,000 and you haven’t been charged any tax (unless you are liable for AMT).
- If you sell your stock within one year of exercising, you’ll be charged income tax at your regular rate on the spread between the price you paid at exercise, and the current market value.
- If you hold on to your stock for at least one year and then sell it at a higher price, you will be charged long-term capital gains tax on the profit you’ve made.
When is the best time to exercise your ISO?
Apart from picking a time that is after your ISOs have vested but before your exercise period expires, it’s difficult to identify the best time to exercise your ISOs. The tax laws for ISO are even more complicated than those for NSO, so it’s best to read our in-depth employee stock options guide to reducing your tax burden and/or ask professional advice from a tax lawyer.
Although it’s important to keep your tax obligations to a minimum, that shouldn’t be the driving factor in choosing when to exercise your ISOs. Other issues to bear in mind include:
- How urgently you need to access cash and what other options you have for getting it
- The size of the spread on your stocks at the moment
- Your current income tax bracket, and whether that’s likely to change in the near future
- How long you can hold on to the stocks after you exercise
- Whether you expect the stocks to rise or fall over the next few years
Next, you’ll need to consider your tax situation carefully and look deeply into the possible tax implications for exercising, holding, and selling your stocks. Whether you have NSOs or ISOs, read the next installment of the employee stock options guide for more advice from EquityBee on how to buy stock options and minimize your tax obligations.