ISOs vs NSOs: The Key Differences and Which One is Right for Your Startup

Attracting top talent is a critical challenge for startup founders. Unlike large corporations, startups need creative ways to offer competitive compensation. One of the most effective incentives is offering employee stock options, which align employees' interests with the company's growth and success.

There are two primary types of stock options: Qualified Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). Each type offers benefits and tax implications that can impact employers and employees. Understanding these differences is crucial to selecting the right option strategy for your team.

In this article, we’ll break down the key distinctions, tax considerations, and pros and cons of ISOs and NSOs to help you make informed decisions about equity compensation.

What Are Qualified Incentive Stock Options (ISOs)?

ISOs are employee stock options that allow employees to purchase company shares at a predetermined price, often called the strike price or exercise price. ISOs are designed to reward and retain key employees by offering favorable tax treatment, provided specific conditions are met.

Unlike other forms of equity compensation, ISOs are restricted to employees only and must adhere to strict IRS guidelines. When employees exercise ISOs and hold the shares for a certain period, the resulting gains may be taxed at the more favorable long-term capital gains rate instead of ordinary income rates. This potential for tax savings makes ISOs valuable for incentivizing employees, which is critical to the company's success.

However, ISOs come with eligibility requirements and time constraints that must be met to maintain their tax-advantaged status. If these conditions are not met, ISOs may be treated as NSOs for tax purposes.

How Are ISOs Taxed?

As mentioned above, ISOs are taxed at the capital gains rate. This means that ISO holders are subject to tax benefits as the capital gains rate is generally lower than the ordinary income rate. It is worth noting that ISOs are taxed at the time of selling the stock (not when vesting or exercising).

When an employee (or person) is granted sock options there is a strike price (which is the value at the time of granting). Once an employee decides to exercise their options, they have the ability to sell their stock or hold on to the stock. If the same person sells their stock at (the fair market value) at a later date the difference between the strike price and fair market value is the profit — or what the employee is taxed on.Check out the long-term capital gains tax rates in 2024 (for the US) below:

Forbes

The Impact AMT Has on ISOs

The Alternative Minimum Tax (AMT) is a parallel tax system designed to ensure that taxpayers, especially those with higher incomes, pay at least a minimum amount of tax regardless of deductions or credits. When it comes to ISOs, AMT can be triggered during the year you exercise your options, even if you don't sell the shares immediately.

Here’s how it works: When you exercise ISOs, the difference between the fair market value of the stock at the time of exercise and the exercise price (also known as the strike price) is called the bargain element. While this bargain element isn't taxed under the regular tax system until you sell the shares, it is considered taxable income under the AMT system. This can lead to an unexpected AMT liability, particularly if the spread between the exercise price and the FMV is significant.

For example, if your strike price is $10 per share, and the FMV when you exercise is $50 per share, the $40 difference per share could be subject to AMT.

The AMT calculation ensures you pay the higher amount between your regular tax liability and your AMT liability. If AMT applies, you’ll need to pay it in the year of exercise, even if you haven't sold the shares and realized the cash. However, when you eventually sell the shares, you may be eligible for an AMT credit, which can help offset future regular tax liabilities.

Because of the potential AMT impact, it’s essential to plan the timing of your ISO exercises carefully. Consider consulting a tax professional to assess the potential AMT exposure and how it might affect your overall tax strategy.

What Are Non-Qualified Stock Options (NSOs)?

NSOs are a type of equity compensation that gives recipients the right to purchase company shares at a predetermined exercise price or strike price. Unlike ISOs, NSOs can be granted to a broader group, including employees, contractors, board members, and advisors.

NSOs are more flexible than ISOs because they are not subject to the same IRS restrictions. However, this flexibility comes with different tax treatment. When NSOs are exercised, the difference between the fair market value (FMV) of the stock at exercise and the exercise price is treated as ordinary income. Later, if the shares are sold, any additional profit is subject to capital gains tax (short-term or long-term, depending on how long the shares are held after exercise).

NSOs are popular among startups because they are straightforward to administer, offer flexibility in who can receive them, and provide potential tax deductions for the company when exercised.

How Are NSOs Taxed?

NSOs are taxed immediately upon exercise. The difference between the exercise price and the fair market value (FMV) at exercise is treated as ordinary income and subject to withholding taxes. When the shares are eventually sold, any further gains are taxed as capital gains (short-term or long-term, depending on how long the shares are held after exercise).

The Impact AMT Has on NSOs

As we mentioned earlier, an alternative tax minimum (AMT) is a potential downside of ISOs. Unlike their counterpart, NSOs are not subject to AMT.

Key Differences Between ISOs and NSOs

While both ISOs and NSOs allow recipients to purchase company stock at a predetermined price, they differ significantly in terms of eligibility, tax treatment, regulatory requirements, and reporting obligations. These differences can impact your company's approach to rewarding employees, advisors, and other contributors and the potential financial outcomes for recipients.

Let’s break down the key differences to help you decide which option best aligns with your company's goals and your team's needs.

Eligibility

ISOs are reserved exclusively for company employees. They cannot be granted to independent contractors, board members, or advisors. This restriction makes ISOs a targeted tool for retaining key employees.

NSOs are more flexible and can be issued to employees, contractors, board members, and advisors. This broader eligibility allows startups to reward internal team members and external contributors.

Tax Treatment

ISOs offer favorable tax treatment if specific holding periods are met. When you exercise ISOs, there is no immediate tax liability unless the alternative minimum tax applies. If you hold the shares for at least 1 year after exercise and 2 years after the grant date, gains are taxed as long-term capital gains, which typically have lower rates than ordinary income.

NSOs, on the other hand, are taxed immediately upon exercise. The difference between the exercise price and the fair market value at exercise is treated as ordinary income. When you sell the shares, any further gains are taxed as capital gains (short-term or long-term, depending on the holding period).

Regulatory Requirements

ISOs are subject to stricter regulatory guidelines under the Internal Revenue Code. To qualify for favorable tax treatment, ISOs must meet the following requirements:

Eligibility: Only employees can receive ISOs.
Holding Period: Shares must be held for at least 1 year after exercise and 2 years after the grant date to benefit from long-term capital gains tax rates.
Exercise Limits: The total value of ISOs exercisable in a calendar year cannot exceed $100,000 based on the grant date FMV.
Plan Approval: The stock option plan must be approved by the company’s shareholders within 12 months before or after the plan is adopted.
Expiration: ISOs must be exercised within 10 years of the grant date (or 5 years if granted to a 10%+ shareholder).

In contrast, NSOs are subject to fewer regulatory requirements. They can be granted to employees, contractors, and board members without restrictions on exercise limits or holding periods. NSOs also don’t require shareholder approval and offer more flexibility in structuring the terms of the option grant.

The stricter regulations for ISOs reflect their preferential tax treatment, while the flexibility of NSOs makes them easier for startups to implement broadly.

Reporting and Withholding

ISOs have simpler reporting and withholding requirements compared to NSOs. When an employee exercises ISOs, there is no immediate tax withholding because the exercise itself doesn’t trigger regular income tax. However, if the employee sells the shares in a disqualifying disposition (before meeting the holding periods), the employer must report the bargain element as ordinary income on the employee’s W-2 form. The company is not required to withhold taxes on ISO exercises, though it must track and report the income if the shares are sold early.

NSOs, on the other hand, trigger immediate tax withholding at the time of exercise. The bargain element (the difference between the exercise price and the fair market value at exercise) is treated as ordinary income. Employers are required to:

Withhold federal and state income taxes (if applicable).
Deduct Social Security and Medicare taxes (FICA).
Report the income on the employee’s W-2 form (for employees) or a 1099-NEC (for non-employees).

Failing to account for withholding on NSO exercises can result in underpayment penalties for the recipient. Accurate reporting and timely withholding are essential for the issuer to avoid compliance issues.

Pros and Cons of ISOs

ISOs offer valuable tax advantages and can help retain key employees, but they come with strict rules and potential tax complexities. Here are the key benefits and drawbacks of ISOs:

Pros

Favorable Tax Treatment: Gains are taxed as long-term capital gains if holding period requirements are met (1 year after exercise and 2 years after the grant date).
No Immediate Tax at Exercise: Exercising ISOs doesn’t trigger regular income tax, allowing employees to defer taxes until the shares are sold.
Employee Retention: ISOs can help retain top talent, as employees must stay with the company to benefit fully.
No Payroll Taxes: ISOs are not subject to Social Security and Medicare taxes (FICA) at exercise.

Cons

Complex Tax Rules: Strict IRS requirements and holding periods must be met to maintain tax benefits.
Alternative Minimum Tax (AMT): The bargain element can trigger AMT liability in the year of exercise.
Limited Eligibility: ISOs can only be granted to employees, excluding contractors and advisors.
Exercise Limits: Only $100,000 worth of ISOs can be exercised per year based on the grant date value.
Market Risk: Employees risk holding shares that may decrease in value before they sell.

Pros and Cons of NSOs

NSOs offer flexibility in who can receive them and simpler regulatory requirements, but they come with immediate tax obligations. Here are the primary advantages and disadvantages of NSOs:

Pros

Broad Eligibility: NSOs can be issued to employees, contractors, board members, and advisors.
Simpler Administration: Fewer IRS regulations compared to ISOs.
No Exercise Limits: No annual limit on the value of NSOs that can be exercised.
Company Tax Deductions: Companies can deduct the bargain element as ordinary income when NSOs are exercised.
Immediate Liquidity: Recipients can exercise and sell shares immediately for cash.

Cons

Immediate Tax Liability: The bargain element is taxed as ordinary income at exercise.
Withholding Requirements: Employers must withhold federal, state, Social Security, and Medicare taxes.
No Tax Deferral: Taxes are due upon exercise, regardless of when the shares are sold.
Market Risk: If the stock price drops after exercise, recipients may owe taxes on a higher value than the shares are worth.
Potential Financial Strain: Recipients need cash to cover taxes at the time of exercise.

ISO vs NSO Which One is Right For You?

Now that we understand the difference between qualified incentive stock options (ISOs) and non-qualified incentive stock options (NSOs) it’s time to understand how and when you should be using both. Both have expected use cases and their own set of pros and cons depending on the use.

When to Choose an ISO

Of course, most employees will likely want an ISO plan as it offers tax benefits. However, it is lesser used and should be reserved for high-value employees. As the team at Investopedia writes, “This type of employee stock purchase plan is intended to retain key employees or managers.” A few times for when you should choose a qualified incentive stock option for your employees:

When offering stock options for an employee (ISOs are not eligible with individuals who are not employees)
When trying to incentivize and retain a high-value employee — this might be a manager or executive that is closely aligned with your companies success.
When your company is in a financial position to offer ISOs instead of NSOs

When to Choose an NSO

While they do not necessarily have the tax benefits of ISOs, NSOs are widely used and are more common than ISOs. Below are a few examples and pros of choosing an NSO instead of an ISO:

When issuing stock options to non-employees. This could be consultants, board members, mentors, and more.
From the team at Pasquesi Partners, “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.”
When looking for a more simple option and straightforward stock option to offer employees

Share Stock Option Information With Your Investors with Visible

Equity compensation, whether through ISOs or NSOs, is a powerful tool for aligning your team’s interests with your company’s success. To build trust and maintain transparency with investors, employees, and other stakeholders, clear communication about your cap table and stock options is essential.

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