ISOs (Incentive Stock Options) vs. NSOs (Non qualified Stock Options)
In any start up there are usually two kinds of options:
1) Incentive Stock Options (ISOs, sometimes called Statutory or Qualified Options) and
2) Nonqualified Stock Options (NSOs, NQSOs or sometimes called Nonquals)
Employees usually receive ISOs. Whereas, NSOs can be granted to anyone - employees, consultants, board members etc.
At Grant Date: There is no taxable event.
At Exercise date : If an employee has exercised ISOs in a taxable year, the difference between the fair value and the exercise price i.e. 'the spread' is included in the calculation of Alternate Minimum Taxable Income. Hence, upon exercise of ISOs employee(s) might be subject to Alternate Minimum Tax.
At the time of sale of stock, if the ISOs acquired are a result of a:
a) Qualifying disposition (i.e. held for more than one year after the date of exercise and more than two years after the date of grant ), the proceeds will be treated as long term capital gains.
b) Disqualifying disposition (i.e. not meeting the holding period as described above in a)) the proceeds will be included and taxed at ordinary income rates.
Tax treatment of ISOs where 83(b) election is filed:
Since holding period requirements i.e. more than one year after the date of exercise and b) more than two years after the date of grant (Disqualifying Disposition), are not met for capital gain treatment, the difference between the fair value and the price paid should be included in gross income. It is taxed at ordinary income rates.
However, in the case of NSOs:
At Grant Date: There is no taxable event.
At Exercise Date: The difference between the fair value and exercise price i.e. the spread, at exercise date is ordinary income.
At the time of sale of stock: The difference between sales proceeds and tax basis (i.e. exercise price + spread included in compensation) is taxed as long term or short term capital gain(s). If the stock is held for more than 1 year then long term capital gain rates apply.
Taxation/ Tax Deduction to Company
In the case of ISOs, a company can take a deduction in the case of a disqualifying disposition when holding period requirements are not met. A company will take a tax deduction equal to the amount of ordinary income deemed to be paid. However, in the case of a qualifying disposition, the company is not entitled to a tax deduction.
In the case of NSOs, the company can take a tax deduction equal to spread included as income of employees.
Both employees and companies need to be aware of the pros and cons of ISOs and NSOs and formulate tax planning strategies to attain maximum tax benefits.
Arushi Bhandari,CPA, MBA recently published an eBook “STARTUP Financing, Equity and Tax" with insights about the impact of JOBS Act & Dodd Frank Act on startup funding, terms like angel, accredited investors, venture capitalists, stock options, Restricted Stock, RSUs. It gives in depth examples & templates explaining documents like Term Sheet, Cap Table, Convertible Securities plus the importance of 83(b) filing.
Links to Download Arushi’s eBook
Apple iBook: STARTUP Financing, Equity and Tax
Kindle edition STARTUP Financing, Equity and Tax
DISCLAIMER: The information provided is intended to educate the readers and a more definite answer should be based on a consultation with a lawyer or CPA.It should not be relied upon as legal advise because the information might be incomplete and answers could change depending upon circumstances and if all facts were known.
