Difference Between Non-Qualified Stock Options & Incentive Stock Options

To understand the differences between incentive stock options and non-qualified stock options, you must first know what they are.

Stock options offer employees equity compensation. Employees are not granted stock shares, but have derivative options on the stock. Employees are explicitly informed about the terms and conditions of stock options in their options agreement. A stock option is granted to employees when the stock of the company has a higher value than the stock price. There are basically two types of stock options. These are NSO (or statutory stock options) and ISO (or statutory stock options).

Let's compare with ISO to see the main differences.

1. Tax Liability

An ISO can often lead to lower tax if the exercise price (or strike) is close to the fair market value as of the grant date. An NSO is only available if the exercise price was at least FMV as of the grant date.

2. Eligibility

NSO and ISO are two different stock options. NSO can only be issued to employees. An ISO, on the other hand can be issued to employees and independent contractors, as well as service providers.Directors who aren't employees also qualify.

3. Taxes due

An ISO does not require tax to be paid until the employee/holder sells the stock option. For an NSO, taxes must paid within 24 hours of the exercise of the stock option. This means that taxes must be paid at the time the stock option is exercised. An NSO is part of an employee's income. An NSO, unlike ISO, involves taxation of the stock before the employee can dispose of it.

4. The company's benefit

An NSO is more advantageous for the company because it allows them to deduct taxes from the time the employee exercises their stock option. An ISO is not possible, making NSO a more practical option for companies.

5. Post-employment exercise period

One of the main differences between ISO and NSO is that ISO must be used within three months of termination of employment. The period cannot be extended if the employee is disabled or dies. An NSO, however, can be exercised anytime before the stock's expiration date. ISOs can only be used if the holder is employed by the company. NSOs, however, are not applicable.

6. Restrictions

The restrictions are where NSO and ISO differ greatly. An NSO must adhere to Section 409A, but an ISO's valuation is more stringent. The Internal Revenue Code Section 422 regulates the ISO. It is, for example, not transferable in any circumstance, except the death of the recipient. NSO is not exempt from this restriction.

Another example is the annual value of a stock. ISO can only exercise $100,000 of stock annually. Any stock that is exercised beyond this limit will be considered an NSO.

7. Rigidity is associated

An ISO is associated with a certain operational rigidity. An ISO is considered an NSO in almost all circumstances. For example, if the ISO is not held for the required minimum period of time, it will be treated as such. It is considered an NSO if the stock isn't held for at least two years after the date the ISO was granted, and one year after the date the stock option was exercised.

These are the main differences between ISO and NSO employers should consider when deciding on stock options for employees.