Incentive Stock Options (ISOs) vs. Non-Qualified Stock Options (NSOs) - A brief comparison

Stock options remain a widely favored method of incentive compensation in the startup and early-stage company realm, serving as a way to supplement restricted cash and ensure that employees are in sync with shareholder goals. Based on my interactions with emerging enterprises, individuals granted options, whether employees or advisors, often lack a comprehensive understanding of the equity holding. This article briefly will delve into the comparison between Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs), shedding light on their resemblances and disparities.

Stock Options - A definition

An employee stock option is a financial contract that gives the holder the right, but not the obligation, to buy a specific number of shares of a particular stock at a predetermined price (known as the strike or exercise price) within a set time frame. The key components are: the Underlying stock, Exercise or Strike price and the Expiration date. The general benefits of Employee stock options offer several potential benefits for both employees and companies:

• Align employees' interests with shareholders for long-term growth and financial gain.

• Vesting options retain employees and provide competitive remuneration without high cash outlay.

• Stock options conserve cash, offer tax advantages, foster ownership feeling, and promote long-term strategic thinking.

Disadvantages of stock options include:

• Concentration risk: Tied to a single company's stock.

• Misaligned incentives: May drive risky decisions for short-term gains.

• Administrative complexity: Managing can be costly.

• Uncertainty of value: Influenced by external factors.

• Complex tax implications.

• Limited liquidity: Vesting periods and restrictions limit value access. (Private Exchanges are improving the liquidity issue, discussed below)

Here's a comparison of Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs):

	Incentive Stock Options (ISOs)	Non-Qualified Stock Options (NSOs)
Eligibility	Can only be granted to employees	Can be granted to employees, contractors, consultants, advisors, etc.
Tax Treatment At Grant	No Tax Impact	No Tax Impact
Tax Treatment at Exercise	No regular income tax at exercise, May trigger Alt Min Tax (AMT)	Taxed as ordinary income on the spread between exercise price and fair market value.  Subject to Payroll Taxes.  Usually IRS Sec 83 option implemented.
Tax Treatment at Sale	If qualifying disposition (held 1+ year after exercise and 2+ years after grant), gain taxed at long-term capital gains rates.  If disqualifying disposition, taxed similar to NQSOs	Any additional gain/loss after exercise taxed as capital gain/loss
Payroll Taxes	Not Subject to Payroll Taxes	The spread at exercise is subject to payroll taxes (Social Security and Medicare)
Annual Grant Limits	$100,000 limit on exercisable value per year.  Any amount above treated as NSO.	None
Company Tax Deduction	None	Tax Deduction as Compensation Expense when exercised for difference of FMV vs. Exercise Price

Hypothetical example of Incentive Stock Options (ISOs). Let's say you work for TechCo, a growing startup. As part of your compensation package, you're granted 10,000 ISOs with the following details:

- Grant Date: January 1, 2022, Exercise Price: $5 per share

- Vesting Schedule: 25% after 1 year, then 1/48th per month for 3 years

- Expiration Date: January 1, 2032 (10 years from grant)

Key events:

1. Initial Grant (January 1, 2022): You receive the option grant, but can't exercise yet, No tax implications at this point.

2. First Vesting (January 1, 2023): 2,500 options (25%) become available to exercise, TechCo's stock price is now $10.

3. Exercise of Vested Options (July 1, 2024): You decide to exercise 5,000 vested options, Cost to exercise: 5,000 x $5 = $25,000, TechCo's stock price is now $15. Spread: (5,000 x $15) - (5,000 x $5) = $50,000. This spread may trigger Alternative Minimum Tax (AMT) considerations. (See AMT discussion below).

4. Sale of Shares (August 1, 2025): You sell all 5,000 shares at $20 per share. Total proceeds: 5,000 x $20 = $100,000. This qualifies as a qualifying disposition (held > 1 year after exercise and > 2 years from grant). Gain: $100,000 - $25,000 (exercise cost) = $75,000This gain is eligible for long-term capital gains tax treatment.

(Side Note: What is the Alternative Minimum Tax (AMT)? The Alternative Minimum Tax (AMT) in the US ensures wealthy individuals pay a minimum level of tax by preventing excessive deductions and credits. Taxpayers calculate their tax liability twice - under standard tax rules and AMT rules - paying the higher amount. Key Features of the AMT are:

• AMT has two tax rates - 26% and 28%, compared to seven brackets in the regular tax system.

• AMT exemption for 2023: $81,300 for single filers and $126,500 for married couples filing jointly.

• Exemption phase-out in 2023 starts at $578,150 for single filers and $1,156,300 for married couples filing jointly.

• AMT limits or disallows many deductions and credits allowed under the regular tax system.

• AMT Calculation Process: Start with taxable income, Add AMT preference items and adjustments, Subtract AMT exemption, Apply AMT tax rates, Compare with regular tax amount, and Pay the higher amount.

Recent Developments: The Tax Cuts and Jobs Act of 2017 significantly altered the Alternative Minimum Tax (AMT) by increasing the exemption amount and income threshold for exemption phase-out. This led to a substantial decrease in the number of taxpayers subject to the AMT, from around 5 million in 2017 to an expected 200,000 in subsequent years.

Non-Qualified Stock Options (NSOs)

Typically, Non-Qualified Stock Options (NSOs) are more prevalent in the United States because companies are attracted to the tax benefits associated with treating NSOs as a deductible expense for compensation. To illustrate, consider a hypothetical scenario involving an employee named Jane who works at TechStart, a thriving technology company. As part of her remuneration package, Jane is awarded 10,000 NSOs with the following specifications:

- Grant Date: March 1, 2022. Exercise Price: $10 per share

- Vesting Schedule: 25% after 1 year, then 1/48th per month for 3 years

- Expiration Date: March 1, 2032 (10 years from grant)

Key events:

1. Initial Grant (March 1, 2022): Jane receives the option grant, but can't exercise yet. No tax implications at this point.

2. First Vesting (March 1, 2023): 2,500 options (25%) become available to exercise. TechStart's stock price is now $15.

3. Exercise of Vested Options (September 1, 2024): Jane decides to exercise 5,000 vested options. Cost to exercise: 5,000 x $10 = $50,000

   - TechStart's stock price is now $20. Spread: (5,000 x $20) - (5,000 x $10) = $50,000

   - This $50,000 is treated as ordinary income and reported on Jane's W-2.

   - Jane owes income tax and payroll taxes on this $50,000. Note, most will take declare the Section 83 option at the time of exercise, especially when the stock price is close to exercise price, avoiding the ordinary income tax.

4. Sale of Shares (October 1, 2025): Jane sells all 5,000 shares at $25 per share. Total proceeds: 5,000 x $25 = $125,000

   - Cost basis: $50,000 (exercise cost) + $50,000 (income recognized at exercise) = $100,000

   - Capital gain: $125,000 - $100,000 = $25,000. This $25,000 is treated as long-term capital gain (held > 1 year after exercise).

When it comes to tax strategies related to NSOs, employees have several options to consider in order to reduce income taxes at exercise. One common tax strategy for NSOs is to hold onto the stock after exercising the options. By holding the stock for a certain period of time, employees may benefit from lower capital gains tax rates compared to ordinary income tax rates. This strategy allows employees to potentially reduce the amount of taxes owed on the stock appreciation.

Another tax strategy for NSOs is to spread out the exercise of options over multiple years. By exercising a portion of the options each year, employees can potentially avoid being pushed into a higher tax bracket due to a large one-time increase in income. This can help employees manage their tax liability more effectively.

Additionally, employees with NSOs may consider using tax-loss harvesting strategies to offset any gains realized from exercising the options. By selling other investments at a loss, employees can reduce their overall taxable income and potentially lower the amount of taxes owed on the NSO gains.

Overall, understanding and implementing effective tax strategies for NSOs can help employees maximize their financial benefits while minimizing their tax liabilities. Opt for early exercise, file 83(b) election within 30 days, hold shares for long-term gains, exercise limited options annually to avoid AMT, relocate to lower tax state, explore "swap" exercises, negotiate extended exercise periods for departing employees.

Private Exchanges - A Liquidity Option for Employees

For a long time, the lack of liquidity in stock options, meaning the inability to sell them before the underlying stock went public, was a significant disadvantage. However, private exchanges have emerged in recent decades to offer a platform for trading options of private companies. Although these exchanges are not as extensive as public stock markets, they cater specifically to employee stock options. Here are some important aspects to consider regarding private exchanges for employee stock options:

1. Specialized platforms like Forge Global, EquityZen, Nasdaq Private Market, and CartaX facilitate private company share trading.

2. Private marketplaces have lower liquidity than public exchanges.

3. Board approval is usually necessary for transferring shares in private companies.

4. Companies restrict the sale of shares or options for employees.

5. Only accredited investors can buy shares on these platforms per SEC regulations.

6. Valuing private company shares is challenging due to limited financial data.

7. Platforms focus on shares of companies preparing for an IPO.

8. Selling private shares involves complex tax implications different from public stock sales.

Although private exchanges offer employees the opportunity to sell their private company stock or options, the process is typically more intricate and limited in comparison to trading shares of public companies. It is advisable for employees to thoroughly examine their company's policies and seek advice from financial experts before engaging in sales through these platforms.

Summary

Stock options are a valuable form of employee compensation that offer the potential for financial gains if the company's stock price increases. However, they come with complexities and risks that must be carefully considered. There are two main types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). Understanding the grant terms, vesting schedule, expiration date, and tax implications is crucial. While stock options can lead to profits, there are risks involved, such as the possibility of options losing value if the stock price drops. The value and appropriateness of stock options depend on individual circumstances, company performance, and market conditions.

Remember, actual scenarios can be more complex, and it's crucial to consult with a financial advisor or tax professional for personalized advice.