The Basics of Equity Compensation

NSOs AND ISOs

There are two main types of stock option programs:

• Incentive stock options (ISOs)
• Non-qualified stock options (NSOs)

NSOs and ISOs possess some similar and some very different characteristics. Let's take a look at each plan.

ISO Basics

Incentive stock options (ISOs) are “qualified” plans that have favorable tax treatment and specific design requirements. Although the Internal Revenue Service gives ISOs favorable tax treatment, there are several rules regarding ISO terms (including periods of vesting and exercise). ISOs are commonly offered by high-tech or start-up companies and are limited to employee participation only. For each recipient, ISOs have a $100,000 limit on the value of the stock that can be vested within a calendar year.

The ISO tax advantage is that no taxes are triggered at exercise of the options, even if a gain has been realized since the grant date, so long as the stock is not sold. The stock can be sold later at which time a tax is assessed. The IRS defines holding periods that must be met to gain the preferential tax treatment.

NSO Basics

The non-qualified stock option (NSO) gives companies greater flexibility in plan design. NSOs do not have preferential tax treatment based on holding periods but there is no limit to the amount that can be vested for each recipient, and they may be granted to more categories of individuals:

• Employees
• Board members
• Consultants

When an NSO is exercised, taxes are paid on the difference (gain if any) between the exercise price (price at grant) and the current market value. If the stock is then sold at a later date, any gain beyond what was realized at exercise will also be taxed.

We will discuss NSO and ISO taxes in more detail later in the course.