ISO vs NSO: What Every Employee Needs to Know About Stock Options

The world is growing rapidly, and so are the tech companies and startups. A powerful and effective tool to help companies with retention and recruitment is – employee ownership. Imagine being handed a golden ticket by your employer to buy your company’s stock – a financial reward more than just a salary or cash bonuses. However, not all stock options are the same. The most common types are ISOs and NSOs.

Are you wondering what stock options you have, what deal is better for you, and how tax preparation services can help you with tax liabilities? In this blog post, we are going to break every stock option down for you. 

What is an NSO vs ISO? 

Stock options are employee’s equity – an opportunity to purchase a certain amount of the company’s shares at a fixed price. In the future, when the stock value rises, you can sell them at higher prices. In other words, we can say – buy low and sell high.

ISO – Incentive Stock Options 

• ISO is only eligible for employees.
• Comes with vesting schedule (waiting period before getting full ownership of the shares)
• Has an expiration date of 10 years.
• Qualifies for special tax treatment (means no need to pay tax while exercising your stock options)
• ISOs are granted to employees based on their fair market value (FMV).

NSO – Nonqualified Stock Options

• Unlike ISOs, NSOs are open to employees, service providers, directors, and consultants. Individuals who are not on the company’s payroll are also eligible for NSOs.
• It may or may not include a waiting period schedule.
• Has a flexible expiration date with no fixed years.
• As NSOs are non-qualified, you have to pay taxes while selling the shares. 

What is an Incentive Stock Option?

An ISO is a stock option that a company only offers to its employees and has a vesting schedule. A vesting schedule is a waiting period during which you would not have full control of your shares until this period lasts. Once the vesting period is over, you can purchase your shares at the initial price of granting and sell them at higher prices.

These incentive stock options expire in 10 years, and you must exercise them before that for maximum gains. Additionally, ISOs are qualified for tax treatments, which means that if you hold ISOs, you don’t need to pay taxes during exercise.

ISO vs NSO Tax Treatment 

Tax implication is one of the critical differences between ISOs and NSOs.

• Tax at vesting—ISOs and NSOs do not experience tax events at vesting or during waiting periods.
• Tax at exercise – no tax event for ISOs while exercising the stocks. On the other hand, for NSOs, you need to pay the ordinary income tax as compensation while exercising. 
• In another case, if you decide to leave the company, you will have 90 days to exercise your ISOs. Otherwise, your ISOs will be considered and treated as NSOs. 
• Alternatively, if you are holding NSOs, there is no 90-day window to exercise the stock options. But it is better to exercise them before the expiry for more gains and benefits.

How are Stock options taxed?

• Incentive Stock Options (ISOs)

1. When ISOs are granted, this does not produce immediate gains subject to income taxes. You have to hold these stock options for a year to have complete ownership, which you can exercise later on. The difference between the current fair market value and the strike price is the potential tax liability, often referred to as ‘spread.’
2. For ISOs, the spread price is included as an Alternative Minimum Tax, while for NSOs, the spread price is considered an ordinary income tax.

• Non-qualified Stock Options (NSOs) 

1. If you sell your shares within a year, you must pay short-term capital gain taxes on the profit you make. On the other hand, if you sell your shares after keeping them for a year, you will pay long-term capital gains taxes.
2. In other cases, NSO holders are likely to pay ordinary income tax while exercising their shares.

Difference Between ISO and NSO

Stock options are compensation options offered by a company to its employees, directors, consultants, and other service providers. Here is a summary of ISOs vs. NSOs that will help you better understand these options. 

ISOs	NSOs
Only employees are eligible.	Employees, directors, contractors, consultants, or any third party is eligible.
The vesting schedule is mandatory.	No waiting period is required.
No tax event while exercising. May subject to alternative minimum tax (AMT)	Ordinary income tax during exercising.
Need to exercise within 90 days of leaving the company.	Have flexible time to exercise till the expiration date.
Has an expiration date of 10 years.	The flexible expiration date depends on the agreement.
May result in AMT taxes depending on fair market value (FMV)	Spread tax as compensation.

ISO vs NSO, which is Better?

Some important factors you need to consider before choosing the best stock option include – business scale, goals, employee benefits, and concerns. For employees, company offers ISOs as part of its best equity compensation plan and tax treatment is favored.

On the other hand, the company also offers NSOs in certain circumstances and is also preferred when

• They need to offer stock options other than employees.
• They are looking for more flexible options with no expiration date and simple tax implications.
• When you don’t need to exercise within 90 days after leaving. 

Are you still confused about which stock options deal is best for you? We can help. At H&M Tax Group, we offer affordable tax preparation services to guide you through the process. Contact us today, and we will ensure you choose the best option.