What is the difference between incentive stock options and non-qualified stock options?

Incentive stock options, or “ISOs”, are options that are entitled to potentially favorable federal tax treatment.  Stock options that are not ISOs are usually referred to as nonqualified stock options or “NQOs”.  The acronym “NSO” is also used.   These do not qualify for special tax treatment.  The primary benefit of ISOs to employees is the favorable tax treatment — no recognition of income at the time of exercise, and long-term capital gains versus ordinary income at the time the stock is sold.  But in the typical exit by acquisition scenario, employees exercise their stock options and are cashed out at the time of the acquisition.  In that scenario, since they sell immediately, they do not qualify for the special tax rates, and their stock options default to NQOs.  So in practice, there tends not to be a material difference in the end between NQOs and ISOs.  If emplyees are in a situation where it makes sense to exercise and hold (for example, if the company goes public), then the benefits of ISOs may be realized.

The discussion below is not comprehensive.  Please consult your own tax adviser for application to your situation. 

Primary differences between ISOs and NQOs 
  Incentive Stock Options Non-Qualified Stock Options
Who can receive? Employees only. Anyone.
 Requirements: Must be issued pursuant to a shareholder- and board-approved stock option plan. Should be approved by the board of directors and pursuant to a written agreement.
  The exercise price must be no lower than fair market value at the time of grant. If the exercise price is less than the fair market value of the stock at the time of grant, the employee may be subject to significant penalties  under Section 409A, including taxation on vesting.
  The option must be nontransferable, and the exercise period (from date of grant) must be no more than 10 years.  
  Options must be exercised within three months of termination of employment (extended to one year for disability, no time limit for death).  
  For 10% (or more) shareholders, the exercise price must equal 110% or more of the fair market value at time of grant.  
  For 10% (or more) shareholders, the value of options received in any one year,  cannot yield stock valued at more than $100,000 if exercised (value is determined at the time of the grant).  Any amount in excess of the limit will be treated as an NQO. No limit on value of granted options.
Tax effect to Company:

The company is generally not entitled to a deduction for federal income tax purposes with respect to the grant unless the employee sells the stock before the end of the requisite holding periods.

Company receives deduction in year recipient recognizes income, as long as, in the case of an employee, the company satisfies withholding obligations.

Tax effect to Employee: No tax at the time of grant or at exercise. Long term capital gain (or loss) recognized only upon sale of stock if employee holds stock acquired by exercise a year or more from exercise and at least two years from date of grant. The recipient receives ordinary income (or loss) upon exercise equal to the difference between the exercise price and the fair market value of the stock at date of exercise.
  But the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the alternative minimum tax. The income recognized on exercise is subject to income tax withholding and to employment taxes.
  Gain or loss when the stock is sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i.e., the amount paid on exercise). When the stock is sold, the gain is long term capital gain if held more than one year from exercise. The gain will be the difference between the sales price and tax basis, which is equal to exercise price plus the income recognized at exercise.
     

Comments

  1. Pradip Dave says:

    I am starting a consultancy business by forming a company type private limited. In a steady state there would be total 10 to 12 persons working actively for the company, however, I intend all of them to be owner of the company. They would start with a part salary or no salary till company starts earning. At least in a year time I want to give them shares and keep on gradually appreciating their work by giving more and more shares and making them responsible for the company business. To avoid any decision paralytic situation I would retain 51% of the shares and share remaining 49% among them. How this can be made possible in Indian scenario. I would be obliged with your guidance. – Pradip

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