ISO & NQSOs: What’s the Difference?
- Two common forms of equity compensation in the tech industry and among startup firms are ISOs and NQSOs
- The primary difference between these two types of employee stock options is the tax treatment
- The right financial plan can avoid paying excessive taxes while still managing the risk of holding shares of your employer’s stock
Many companies in the tech industry, particularly early-stage firms, compensate employees in the form of incentive stock options (ISOs) and non-qualified stock options (NQSOs). In lieu of a higher cash salary, a stake in the company’s future is offered through options.
Making the Most of Your Equity Compensation
It’s often confusing, though, for individuals to understand how these potentially valuable pieces of an equity compensation package work. Moreover, one wrong decision can be extremely costly. Having the right plan for your ISO and NQSOs is paramount to building your net worth quickly. Grasping the key differences between these two types of employee stock options is critical.
ISOs Feature Favorable Tax Treatment
ISOs are a popular way for firms to pay or reward employees through equity. Companies also use ISOs to retain workers. For individuals holding options, there is the potential to have the right to buy shares of the company’s stock at a discounted price along with favorable capital gains tax treatment. NQSOs, however, usually face higher ordinary income tax rates. That makes a significant difference for taxpayers in a high marginal tax bracket.
ISO Ground Rules
There are several key requirements with ISOs:
- First, the options’ exercise price must be equal to or greater than the fair market value (FMV) of the stock on the grant date.
- Next, ISOs cannot be transferred at death, so you must have a plan of when to exercise the options and how many at a time.
- Speaking of timing, you must exercise your ISOs at the earlier of 10 years of the grant date and three months of leaving the company (there are extenuating circumstances for disability or death).
- Finally, as with all forms of equity compensation, checking with your HR department to find out any other specifics is wise. Not only are there key timing rules in place with ISOs, but there’s a dollar-amount limit. The FMV of the stock underlying the ISOs that are first able to be exercised during a single calendar year cannot exceed $100,000 – that value is determined on the grant date.
By checking all of those boxes, you won’t face income tax liability on the grant date or when they are exercised. There are, however, alternative minimum tax (AMT) impacts based on the difference between the share price and the strike price at which the ISOs are exercised.
Another tax upshot? After exercising the options and receiving stock, if you hold the shares for the later of one year following the exercise date or two years after the ISO grant date, any stock price gains are treated at favorable long-term capital gain rates. This is known as a “qualifying disposition.” If you do not meet those qualifications, the sale is considered a “disqualifying disposition,” and that’s when NQSOs can enter the scene.
Tax Planning with Non-Qualified Stock Options
NQSOs do not have the favorable tax treatment of ISOs. At a high level these options are granted to a range of employees down the pecking order. While the NQSOs are not taxable on the grant date, you will face ordinary income tax rates at the time of exercise. That liability is equal to the difference between the value of the underlying stock when the options are exercised and the NQSOs’ strike price. One possible tax-savvy strategy with NQSOs is an 83(b) election in which you elect to exercise and pay income tax before the options vest.
How To Capture a Lower Tax Rate on Shares Received from NQSOs
Employees granted NQSOs who strike on their options will have amounts withheld for income tax and employment taxes. When the stock is later sold, gains or losses are treated as either short-term or long-term capital gains. Short-term gains, those earned on sales within a year of acquisition, are taxed as ordinary income while long-term gains on shares owned for more than a year face a lower tax rate. By waiting to sell the stock received from striking on options, you can pay a lower tax rate on gains.
Where People Without a Plan Go Wrong & How We Help
So there is significant tax-saving potential even with NQSOs. Unfortunately, we find that many tech-industry professionals fail to realize that a bit of strategy can go a long way toward minimizing their tax bill. At Archer, we work with our clients to keep track of their ISOs to prevent that. The result is sometimes thousands of dollars or more of taxes avoided.
It’s also common for employees at private companies to exercise stock options, then sell shares, immediately in advance of the firm’s sale. Another situation around a liquidity event is that ISOs can be canceled to go along with the terms of the transaction – option holders are simply paid the price difference between the stock’s takeover price and the options’ strike price. Employees often sell the stock quickly after exercising the options so that they have cash available to pay taxes, including AMT tax. A cash exercise or cashless exercise are strategies we help craft. This is another situation where good cash flow planning can prevent paying excessive taxes.
The Bottom Line
At Archer Investment Management, we find that folks holding a substantial number of ISOs quickly grow unsure of what the best path forward is with their employee stock options. Our experienced team of financial planners specialize in helping tech industry professionals make the most of their equity compensation. Doing so puts our clients on the fast track to financial independence.