The Difference Between ISO and NSO and What Startups Need to Know

As the owner of a fast-growing startup, you have a million things on your plate. While you may be considering whether or not an Incentive Stock Option (ISO) or a Non-qualified Stock Option (NSO) is best for your company and employees, it’s most likely not resting at the top of your list. 

However, they can play an important role in attracting talent to your workforce. Offering stock options in replacement of higher compensations is a trend startups are beginning to partake in, and employees love it. 

Options create more interest in the success of the company and should the company take off, it has the potential to provide more than a compensation package would have included. 

Once you’ve decided to include stock options in your compensation packages, you’ll have to decide which is the better option for your company. The truth is, ISO and NSO both have their benefits and downfalls and it can be complicated to determine which will be more beneficial over the other. 

Thankfully we’ve compiled important information that will explain the difference between the two and help you make your decision. 

ISO vs NSO: What’s the difference?

The easiest way to understand the difference between ISO and NSO is to define them.

An Incentive Stock Option (ISO) is a benefit given to employees and allows them to purchase stock in the company at a discounted price. This option requires employees to pay taxes on the stock at the time of purchase. A tax may be applied at the time of sale as well but that is dependent on how long the stock was held. Employees have to wait until their stocks are fully vested before they can exercise the option.

A Non-qualified Stock Option (NSO) grants the employee, and people associated with the company like contractors, lawyers, etc., stock within the company at a set rate plus tax. After a predetermined amount of time, the employee has the right to exercise their option or lose out. If they exercise the option, the employee is required to pay taxes on the difference between the current price and the price at the grant date. What’s leftover is considered compensation for the employee.

More about Incentive Stock Option (ISO)

Like many things, ISO has its perks, but it also has its downfalls. From a company standpoint, an ISO is a good option because it leads to lesser tax liability and isn’t subject to the valuation requirements of Section 409A rules. On the downside, there are plenty of other strict requirements an ISO must meet in order to keep its ISO status.  

1. An ISO leads to lesser tax liability

Compared to an NSO, ISO has less tax liability. In an ISO, you pay taxes on the initial purchase and can time your sale to ensure you do not have to pay taxes again. An NSO requires that you pay taxes on your initial purchase and again on your total profit. 

2. ISO is not subject to the Valuation Requirements on Section 409A

ISO does not have to adhere to the strict rules of Section 409A, which, in short, regulates deferred payments, usually by adding a steep tax. This is a benefit of using ISO as opposed to NSO because following the valuation requirements tends to be pricey and can often demand the attention of a professional.  

3. ISO is subject to many restrictions

Using ISO comes with a variety of regulations ordered by the Internal Revenue Code. Some of these regulations include: 

  • Unless there is a death, ISO are non-transferable
  • There is a yearly cap, meaning any shares over $100,000 will be treated as an NSO. If you use ISO, you and the employee are responsible for paying close attention to your numbers so they do not exceed the cap. 
  • Should an employee own more than 10% of the company, the price when the stock is exercised should be at least at a 110% premium over the fair market value.
  • Unfortunately, ISO is only available for employees, limiting the number of people in your network who can earn stocks in your company. 

More about Non-qualified Stock Option (NSO)

Similar to ISO, NSO has a list of positives and negatives from a company standpoint as well. That said, non-qualified options are often the preferred method for companies. Firstly, because of the way NSO are provided. 

NSOs are seen as income and result in tax deductions. They’re also simple to use and can be used as a crutch if the qualifications of an ISO are not met. One negative for an NSO is that it does have to meet the requirements of Section 409A.

1. An NSO give the company tax deductions

With NSO, companies are able to take tax deductions when the employee chooses to exercise their option in the stock. Because of the way they are structured, NSO earnings are viewed as income for the employee, hence the tax deductions. 

2. NSO is relatively simple

As mentioned before, ISO is riddled with requirements. NSO, on the other hand, does not have as many strict requirements to maintain its status. In fact, when an ISO does not maintain its position by adhering to the regulations, it drops down to an NSO status. 

3. You may transition from an ISO to and NSO

Typically, when an employee or company fails to meet the required regulations it is because there was an issue with the time of holding. In order to maintain the ISO status, and not transition to an NSO, you must do two things: 

  • The employee must hold the stock for two years after it was granted
  • The employee must hold the stock for one year after the stock option was exercised 

Again, from an employer’s perspective, NSO are often the preferred stock optioning method.

The Importance of 83b Election

NSOs (and ISOs under certain circumstances) give your employees the ability to file something called an 83b election. If your company gives out options to employees, those employees have 30 days to complete form 83b and file it with the IRS.

What does an 83b election do?

This election process allows stockholders to pay taxes on the pre-vested, pre-exercised options, at their current price. Assuming the value of their options go up, this will save them a larger tax burden when they are vested or choose to exercise their options.

How to plan for employee stock tax implications 

Planning and deciding which route is best for your company can be difficult. As mentioned previously, there are plenty of reasons to lean towards Incentive Stock Options, just like there are plenty of reasons to lean towards Non-qualified Stock Options. 
If you find yourself searching for answers you should turn to a qualified accounting partner. They can help point you in the right direction and assist in making decisions that are best for your company. Consider reaching out to Pasquesi Partners for more information as to how they can support your business.