Equity: Diving into your Options
Do you ever feel really confident about your understanding of a certain subject matter.. then realize how nuanced the space is and understand how little you actually know? That was me after diving into Incentive Stocks Options (ISOs) and Non-Qualified Stock Options (also called Non-Statutory Stock Options or NSOs).
Fundraising and managing a cap table is complicated enough when growing your startup. Figuring out the ideal option pool can be difficult, but you should also understand the difference between ISOs and NSOs, when you can offer each, what the limitations are, and, of course, the tax implications. Let’s start from the beginning: what is the difference between the two?
ISOs
In general terms, ISOs are stock options granted to employees offering tax benefits. These options are only available to employees and financial gain is not recorded as income; rather, it is recorded as a capital gain generally limiting the tax obligations to 20%. The tax liability stems from an increase from the option price (how much the holder paid for the stock) to the sale price (how much the holder sold the stock for).
NSOs
NSOs are generally available to anyone and have far fewer requirements than ISOs. The tax burden is heightened and the holder incurs income taxes on any gain from an increase in the price of the option and the current market value of the stock at the time it is exercised. Therefore, one may owe up to 39.6% on these unrealized gains. Then, the holder is liable for capital gains tax (presumably 20%) on any increase from the price at the time of exercising the option to the sale price.
There may be some instances where an NSO is preferential for tax purpose, but that is too much accounting right now for me and is likely only in complex circumstances. The limit on taxable gains is generally 20% for ISO rather than paying income taxes after purchasing stock while still paying capital gains tax at their sale.
The IRS Weighs In
Now, I really hope all of this is helpful and I’m providing great value, but what kind a future lawyer would I be without citing to a reliable source. Who better than the IRS to break down key differences between these two types of stock options, which they do in this article. There are a number of forms you (or your accountant) will likely need to understand including Forms 6251, 3921, and 3922; publication 525 by the IRS is also helpful for understanding this tax liability.
Breaking Down the Statute — 26 U.S.C. 422 Incentive Stock Options
I wish I could stop here, but lawyers wouldn’t make any money if these topics were so clear. There are a number of exceptions and requirements to understand when issuing these options.
The $100K rule is a must-know when issuing ISOs to employees. In short, if an employee sells $100K worth of their ISOs in one year, any additional options sold will be treated as NSOs. In long, 26 U.S.C. 422(d)(1) states:
“[t]o the extent that the aggregate fair market value of stock with respect to which incentive stock options . . . are exercisable for the 1st time by any individual during any calendar year . . . exceeds $100,000, such options shall be treated as [NSOs].”
Additionally, there are certain requirements holders of an ISO must ensure are present in order to receive the preferential tax treatment. These requirements may be found at 26 U.S.C. 422(b)(1)-(6). These include (paraphrasing):
- having stockholders approve the ISOs at least 12 months before or after the stock option plan is adopted;
- the option is granted within 10 years from the earlier of the stock option plan or stockholder approval;
- the option cannot be authorized 10 years after it’s granted;
- option price is not less than fair market price of the stock at the time it is exercised;
- the stock option is not transferable; and
- the option holder does not own more than 10% of total combined voting power of all classes of stock; however, there is an exception under (c)(5).
There are a few other considerations and special rules in the statute, including good faith valuation, permissible provisions, transferability, and more.
Now, hopefully, you have a basic understanding of the differences between ISOs and NSOs. Again, this should not be taken as legal advice and always, always work with your attorney and accountant to make sure things such as offering stock options are done correctly.
*This is one law student’s input on stock options, mainly the differentiation of Incentive Stock Options and Non-Qualified Stock Options. This should not be taken as legal advice.*
