What’s the difference between an ISO and an NSO?

Takeaway: ISOs are only available to employees of the company and have more favorable tax treatment, though the benefits of this favorable tax treatment are not always realized by option holders. NSOs can be issued to consultants and have less favorable tax treatment.

Incentive stock options (ISOs) and nonqualified stock options (NSOs) are two types of equity compensation that startups can offer to their employees. While both types of options provide employees with the opportunity to purchase company stock at a future date, there are some key differences between ISOs and NSOs that startups should be aware of.

Here are some of the main differences between ISOs and NSOs.

Eligibility

ISOs are only available to employees of the company, while NSOs can be offered to both employees and non-employee service providers, such as consultants or advisors.

Tax treatment

The tax treatment of ISOs and NSOs is different.

ISOs are eligible for special tax treatment under the Internal Revenue Code, which means that employees who exercise their options may be subject to lower tax rates. ISOs may provide a tax advantage to the holder if (i) the optionee does not sell the shares before the date that is at least two years from the date of grant and one year from the date of exercise and (ii) the optionee is not subject to alternative minimum tax (AMT) in the year of exercise. The tax benefit for ISOs is that there is no tax withholding or FICA payroll tax when the holder exercises the option and the spread between the sale price and the exercise price is taxed as a capital gain. There are additional limitations for taxpayers that are subject to the AMT. Lastly, ISOs lose their status as ISOs three months after the employee’s service to the company has terminated so if the company wants to extend the post-termination exercise period for that option beyond three months, the option will convert to an NSO.

When an NSO is exercised, the grantee is taxed based on the spread between the fair market value and the exercise price and employers must withhold payroll taxes for employee NSOs. NSOs also offer more flexibility to amend options to extend the post-termination exercise period or to reprice underwater options (i.e., options where the fair market value is lower than the exercise price).

Conclusion

ISOs and NSOs have some key differences in, among other things, eligibility and tax treatment. Equity compensation is complicated, and startups should always carefully weigh these factors and consult with legal and tax professionals to determine which type of option is best suited for their business and their employees and other service providers.