Understanding the Differences between U.S. Tax Qualified and Nonqualified Stock Options

February 17, 2016 Louis Barnett Barr

To read this article in Hebrew click here.

This article will summarize the basic differences between U.S. tax-qualified incentive stock options (“ISOs or “qualified stock options”) and nonqualified stock options (NSOs).

From the option holder’s perspective, the main tax benefits of an ISO are that, if the option-shares are held for two years from the date of the grant of the option and one year from the date of the exercise of the option, (i) there is generally no tax upon the exercise of the ISO (subject to the Alternative Minimum Tax “AMT” Rules, (ii) there is no tax imposed until the sale of the stock relating to the option and (iii) the gain is all capital in nature. In the case of an NSO, the difference between the exercise price of an NSO and the fair market value of the stock received upon exercise (the “spread” or “in the money” amount) will be recognized as compensation/ordinary income.

Therefore, as a practical matter, to the extent an option will only be exercised in anticipation of a sale of the stock shortly thereafter, there is generally not as a substantial advantage to the use of ISOs. Similarly, if the option is not “in the money” at the time of exercise, the difference between an ISO and NSO is not as significant.

From the employer’s perspective, there is no deduction for an ISO, while upon exercise of an NSO the employer will be entitled to a deduction equal to the “spread” recognized as income by the employee. Also, the initial plan and any future allotments to the option pool must be approved by the stockholders.

To maintain ISO treatment:

  • ISOs must be granted pursuant to a written stock option plan specifying the total number of shares that may be issued as ISOs that was adopted by the company’s board of directors and approved by the shareholders.
  • Options may be granted only to an employee of the company or its parent or a subsidiary (grants to non-employee directors or independent contractors or to an employee of a sister company are not permitted).
  • As noted above, the option holder must not sell the stock for one year from the date of the exercise of the option, and for two years from the date of the grant of the option. If he does sell the stock before those time periods elapse, they will be treated as NSOs, i.e., the spread is compensation income to the option holder and deductible to the company.
  • The option exercise price must be at least fair market value (“FMV”) of the stock on the date of grant (110% of FMV if the option holder owns more than 10% of voting power of all stock outstanding).
  • The aggregate FMV (determined as of the grant date, e.g., generally the exercise price) of stock bought by exercising ISOs that are exercisable for the first time cannot exceed $100,000 in a calendar year. To the extent it does, such options are treated as NSOs.
  • The option holder must exercise the option while an employee or no later than three (3) months after termination of employment (unless disabled, in which case this three-month period is extended to one year.)
  • The option must be granted within 10 years of the earlier of adoption or shareholder approval.
  • The option must be exercisable only within 10 years of grant (5 years from the time of the grant if the option holder owns more than 10% of voting power of all stock outstanding).
  • The ISO agreement must specifically state that ISO cannot be transferred by the option holder other than by will or by the laws of descent and that the option cannot be exercised by anyone other than the option holder.

Click here for an example of the benefit of ISO

Louis is the head of the Tax practice at SWA, with a strong focus on executive compensation and business formation and structuring as well as comprehensive experience in advising on mergers and acquisitions, especially involving start-ups.

Louis Barnett can be reached at 646 328 0783 or lbarr@swalegal.com

This SWA publication is intended for informational purposes and should not be regarded as legal advice. For more information about the issues included in this publication, please contact Louis Barnett Barr. The invitation to contact is not to be construed as a solicitation for legal work. Any new attorney/client relationship will be confirmed in writing.