Early-stage startups often use employee stock options to compensate employees and align the two parties’ interests. Further complicating the dance of employee equity compensation is the fact that there are not one, but two forms of stock options used by most startup companies: ISOs and NSOs.
One of the main differences is that ISOs can only be granted to employees, while NSOs can be granted to consultants, advisors, and directors as well as employees. If NSOs work for both, then why do most early stage companies grant their employees equity options in the form of ISOs instead of NSOs?
The answer: When it comes to tax treatment, ISOs have special advantages, as laid out in the Internal Revenue Code (IRC).
Non-Qualified Stock Options (NSOs, Sometimes NSQOs)
Called "non-qualifying" because they don't qualify for ISO treatment, NSOs are the simpler of these two forms of stock options. They may include a vesting schedule or may not. Taxation on NSOs first occurs when they are exercised and is based on the spread between the fair market value (FMV) of the stock at the time of purchase and the exercise price (also called strike price) of such options. This is usually zero, but not always.
The difference between the exercise price and FMV is treated as ordinary income tax, not capital gains. As such, they'll be taxed at the ordinary income tax rate. They'll also be charged employment taxes if they are an employee.
To qualify for long-term capital gains treatment on the sale of stock purchased through an NSO, the sale must both:
- Have a holding period of one year (that is, be held for one year after purchase)
- Come from options granted at least two years prior to the sale
Stock with held less than one year after purchase or less than two years after grant date will be typically be subject to higher ordinary income tax treatment.
It is not possible to file an 83 (b) election for NSOs (hence their designation as “non-qualified”).
As an interesting side note, because the exercise of NSOs is considered compensation, they result in a tax deduction for the issuing corporation—but we won’t get into this now.
Qualified Incentive Stock Options (ISOs)
Incentive stock options (ISOs) may only be offered to employees, and expire 10 years after their issue. At most companies, they typically expire 90 days after employment is terminated, though there are some companies that allow a longer window.
They almost always come with a vesting schedule, and many companies will offer early exercise when they are unvested in an attempt to maximize employee gain and minimize taxes.
One of the qualifications for an ISO is that it must be equal to the FMV at the date of the grant. There are no income tax liabilities incurred for holders of ISOs at the time of exercise, but they must pay AMT (Alternative Minimum Tax) that tax year on the amount the FMV exceeds the option price at the time of the grant.
This is situation unlikely, but could occur in a scenario where they were granted at a certain price by the company and a new 409a valuation was completed between their grant/purchase and exercise.
Like NSOs, ISO stock is taxable at the long-term capital gains rate if: the stock is held for at least one year after exercise and the option grant date is over two years prior to the sale. In the case that early exercise is allowed, ISOs are eligible for the 83 (b) election, which allows you to avoid their taxation as income and also starts the clock on their consideration as capital gains.
You must file the 83 (b) election within 30 days! There are NO exceptions. Learn more about how to do that in the article Why You Should File Your 83 (b) Election.
Watch out for AMT liability. In the case that you don’t exercise your ISOs at, you could be taxed when they vest at the AMT rate, which can present a rather hefty tax burden.
Years ago, as the first engineer hired at a growing startup, I purchased a significant number of my shares after they had already vested when I was leaving the company—my tax bill ended up being over $60k and I had to get a payment plan from the IRS in order to pay off my tax liability.
Because of their favorable tax treatment, ISOs come with a few further limitations:
- The FMV of any ISOs exercisable for the first time during a calendar year cannot exceed $100,000 based at the FMV at time of grant (anything in excess of this is taxed as NSOs)
- If you're a significant shareholder (your number of shares totals more than 10% of the company's stock) your ISOs must have an exercise price of at least 110% the FMV, and their expiration date is five years after the grant date
- ISOs can only be transferred after the recipient dies
409A valuations are independent appraisals of a startup's common stock. Startups should use an independent, outside valuation firm to get a 409A valuation before offering stock options to employees to avoid fines and legal issues with the IRS.
They are mostly covered above, but it pays to know the phrase “disqualifying disposition." One of these can only occur if you’ve filed the section 83b election (thus the name). If you sell less than two years after the grant date, you will have a disqualifying disposition on your hands, you're no longer eligible for long term capital gains taxes.
Regardless of the time of grant, a year must also have passed since your 83 (b) election date, or you will have another case of a disqualifying disposition, and a higher tax burden will result.
- NSOs (Non-qualified Stock Options) can be used to compensate employees, consultants, directors, business partners, and advisors.
- ISOs (Incentive Stock Options) can only be used to compensate employees.
- NSOs are taxed as regular income at the time of exercise and are not eligible for an IRS section 83b election.
- ISOs have no tax liability at the time of exercise you take an IRS 83b election.
- ISOs and NSOs will be taxed at the capital gains tax rate if they are held for a minimum of 2 years after the date of exercise.
- Certain disqualifying dispositions can result in a higher tax burden.