ISO vs NSO – Which is better?

When it comes to granting or receiving ISO vs NSO, both the granting entity and the receiver thinks about which is better for them. The granting entity will typically want to offer either of the two that is most beneficial to them. So also, the individual to whom the ISO or NSO is granted also considers which is better for them.

Here, we shall discuss the key differences and similarities between these two stock options and which is better between ISO vs NSO.

In order to fully understand why employees and issuing companies differ in their views about which is better between ISO and NSO, let us first understand what ISO and NSO mean.

Due to the tax advantage associated with ISOs, the Maximum Fair Market Value (FMV) that can be exercised annually is one hundred thousand dollars ($100,000). This maximum FMV that can be exercised is based on the ISOs FMV at the time it was granted. Generally, when an ISO is granted to an employee, they have to exercise their right to make the purchase before they will actually own the shares. The date on which the ISO is granted is known as the grant date.

When an ISO is granted, it will usually have a vesting schedule. The vesting schedule outlines the time-based or performance-based actions that must be met by the employee before they get full ownership of the shares. When the employee gets full ownership of the granted ISO shares, the shares are said to be fully vested.

Unlike NSOs, Incentive stock options can only be granted to the granting entity’s employees. These stock options normally expire ten (10) years after they were granted, but in a case where the employee dies or becomes disabled, the expiration date may be extended.

In a situation where the appointment of the employee to whom ISO was granted gets terminated, the employee will have a limited period to exercise their ISO. This limited period is commonly referred to as the Post-Termination Exercise Period (PTEP). The PTEP for most granted ISOs is three (3) months. However, some corporations that grant ISOs may offer longer expiration dates. Furthermore, for some companies, once the employee’s appointment gets terminated, any ISO that was granted and has not yet been exercised by the employee automatically becomes forfeited.

ISOs are usually offered to employees as incentives for good work in addition to their regular salaries or as part of the hiring contract, or promotion package. ISOs cannot be transferred from the employee to whom it was granted, to any other person except in the case of the death of the employee. In the United States, only entities that are taxed as corporations with respect to payment of federal taxes can grant ISOs to their employees.

Employees who are shareholders of the granting entity and have up to ten percent (10%) shareholding must pay a premium when they exercise their ISO. The premium is usually one hundred and ten percent of the share’s Fair Market Value (FMV) at the time of exercise. Additionally, for these employees, the expiration date for their ISOs is usually five (5) years after it was granted.

In a situation where the employee does not exercise their rights to purchase the shares, then they will not own the shares associated with the granted ISO. The date on which the employee decides to actually purchase the shares is known as the exercise date.

See also: Exercising stock options

NSOs are also referred to as nonstatutory stock options and they generally do not qualify for the favorable tax treatment which ISOs enjoy. The vesting schedule of NSOs can be either graded or cliff. A graded vesting schedule means that a specified percentage of the shares granted to you will be available for purchase annually. A cliff vesting schedule means all the granted NSOs will be vested at the same time after a specified period.

When the holders of NSOs exercise their options, they are taxed on the spread (difference) between the NSOs strike price and its current market price. The expiration date for these stock options varies from one company to the other based on the terms in the stock option agreement. Holders of nonqualified stock options that have up to ten percent (10%) shareholding in the issuing company pay the Fair Market Value (FMV) of the shares at the time of exercise.

In a situation where the appointment of the employee to whom NSO was granted gets terminated or the contractor, consultant, lawyer, etc. no longer offers services to the granting entity; they can still exercise their stock option as long as it is not expired. Unlike ISOs that can only be issued by corporations, nonqualified stock options can be issued by partnerships, limited liability companies as well as corporations.

NSOs can be transferable or not; their transferability depends on the stock option plan. Additionally, there is no cap on the amount that can be exercised annually. In a situation where the NSO holder does not exercise their rights to purchase the shares, then they will not own the shares associated with the granted NSO.

Which is better ISO vs NSO

As stated earlier, employees consider ISOs as better whereas employers consider NSOs as better. The reason why there is this disparity in the agreement is due to the issue of taxation and the diversity to whom these options can be granted. We shall discuss this further below

NSO vs ISO, which is better? looking at the company’s perspective

The major reason why companies prefer issuing NSOs instead of ISOs is that they can issue these stock options not only to employees but to other stakeholders and service providers of the company. Additionally, they can withhold the tax amount for employees who exercise their NSOs. The minimum nonqualified stock options exercise withholding requirement is twenty-two percent (22%) for up to a million ($1,000,000) and thirty-seven percent (37%) for over one million. These values are the spread value i.e the difference between the grant price and the current market price at the time of NSO exercise.

ISOs offer none of these advantages, first, they can only be offered to employees and secondly, the company cannot deduct withholding taxes on incentive stock options.

NSO vs ISO, which is better? looking at the employee perspective

Employees consider ISO a better incentive because they are usually not taxed at the time of exercise. However, if the difference between the exercise price and its current market value is above seventy-three thousand and six hundred dollars ($73,600) for individuals and above one hundred and fourteen thousand six hundred for married persons filing their taxes jointly, they could be tax the Alternative Minimum Tax (AMT) rate on the ISOs. This is quite unlikely though because, for most US states, AMT is zero. The only states that charge AMT is Colorado, California, Minnesota, and Iowa. Their the AMT rates are 3.47%, 7%, 5.8%, and 7% respectively

Additionally, unlike NSOs that are taxed at the ordinary income tax rate at the time of sale, ISOs are taxed at the capital gains rate which is usually cheaper. But in order for ISOs to be taxed at the capital gains rate, they have to be held for two (2) years from the grant date and one year after they were exercised.

NSOs do not offer any offer AMT advantage as they are taxed at the ordinary income tax rate both at the time of exercise and at the time of sale.

Conclusion

For employees and all other holders of either ISO or NSO, it is important to note that having either of these stock options is of no use unless you exercise your stock option and purchase the shares associated with them. Additionally, the agreement terms, as well as other restrictions and regulations, should be taken into consideration either when exercising or selling. This will aid in deriving the most benefits from your stock option.

Regardless of being an employer or employee, it is important that you understand the advantages either ISO or NSO presents to you so as to make the right decision either when issuing or receiving either of these stock options.