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Non-qualified Stock Options vs. Incentive Stock Options: Which is right for your company?

Anchin AlertNovember 12, 2020Megan Klingbeil and John Ingrassia,
Partners in Anchin’s Consumer Products Group

Non-qualified Stock Options vs. Incentive Stock Options: Which is right for your company?

Being able to attract and retain key talent can substantially aid a company’s ability to succeed and grow. There are many offerings that can appeal to key employees, and one that tends to be popular is a stock option plan. If you are looking to provide your employees with an incentive stock option (“ISO”) plan or a non-qualified stock option (“NSO”) plan, you will want to make a careful and informed choice. 

ISOs are specifically reserved for employees, while NSOs can be granted to employees as well as to Directors, service providers or other key relationships to the company. These different types of options are taxed very differently and ISOs also have very strict requirements.

When choosing whether to issue an ISO plan or a NSO plan, there are a few things to consider to determine which type is the right fit for your company.  ISOs could be advantageous when a company is starting out and the options are lower in value.  As a company matures, the value of the options is often too high to meet the requirements for an ISO plan. Both types of options give the right to the employee to purchase the stock at a strike price set at the date of grant.  However, whereas the exercise of an ISO does not trigger a taxable event, the exercise of an NSO triggers tax at ordinary income rates on the intrinsic value, calculated as the difference between the fair value and the exercise price, at the date of exercise (and an equal deduction for the company). The NSO could be advantageous in specific circumstances, such as a quick exercise, so there is no intrinsic value when the holding period begins. 

Furthermore, when an employee exercises an ISO, while the exercise does not create a taxable event for regular tax purposes it does create an income adjustment for Alternative Minimum Tax (AMT) purposes for the employee.  This may increase the employee’s tax in the year of exercise.  Regardless of the type of option exercised, the holding period on the stock purchased begins on the date of exercise.  For the appreciation from that date until the stock is sold to qualify as long-term capital gain, the stock must have been held for at least one year (and if acquired by exercise of an ISO, the date of the sale of the stock must be at least two years from the grant date of the ISO).  If your company is more mature, options granted to employees may not qualify to be treated as an ISO since each employee is subject to a $100,000 per year limitation. If the aggregate fair market value of the option granted to each employee is over $100,000, any excess for that employee is treated as a NSO.  The $100,000 limit is calculated in the first calendar year in which the option is exercisable.   

Based on the above, the decision on the type of options you grant should be based on the fair value of the options and the growth trajectory of your company. 

For further examples on how this scenario would apply to your situation, please contact Megan Klingbeil or John Ingrassia, Partners in Anchin’s Consumer Products Group, or your Anchin Relationship Partner.

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