ISO vs NSO: Navigating Tax Implications for Stock Options

Employee stock options can be a valuable part of your compensation package. However, understanding the tax implications of Incentive Stock Options (ISO) vs. Non-qualified Stock Options (NSO) can feel as clear as mud. Don’t worry; this article helps you understand these often misunderstood financial instruments, breaking down the key differences between ISO vs NSO.

Key Takeaways:

• Types: Two main stock options: ISOs vs NSOs.
• ISO Tax: ISOs may get favorable tax rates but can trigger AMT.
• NSO Tax: NSOs are taxed as ordinary income at exercise, then as capital gains upon sale.
• Eligibility: ISOs for employees only; NSOs for employees, contractors, and advisors.
• Restrictions: ISOs have holding periods and a $100,000 limit; NSOs do not.

What are Stock Options?

Stock options allow employees to buy company stock at a set price, hopefully at a discount. You might receive stock options as part of your compensation package in addition to your regular salary. There are two main types of stock options: ISOs and NSOs.

ISO vs NSO: What’s the Difference?

Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs) let you buy company shares at a specific price. But, how the IRS taxes each one is where things differ.

Incentive Stock Options (ISOs)

Think of Incentive Stock Options (ISOs), sometimes called Statutory Stock Options, like that cool vintage tee you snagged at a thrift store – they have the potential to be valuable down the line.

This is because you may not owe taxes until you sell the stock, which means paying the more favorable long-term capital gains tax rate, not the higher ordinary income tax rates if certain conditions are met.

ISOs are typically only available to employees. To get those tax perks, you usually have to hang onto those ISO stocks for a while, at least one year after buying (exercising) them and two years after receiving them. This holding period comes with a level of risk because the stock price can decline between your purchase and sale.

You’re subject to a yearly $100,000 limit on ISOs when you factor in fair market value on new exercises. Watch for that if you’re sitting on many stock options. 

Even if they tick all the boxes above, AMTs are another potential hurdle.

The AMT (Alternative Minimum Tax) ensures that high-income earners pay certain taxes. Here’s the catch with ISOs: if you sell them before the holding periods, you’re taxed as if they’re NSOs.

Plus, you could still be subject to AMT, which is like a double whammy of taxes. You won’t get any potential tax benefits, even if the ISOs qualify under IRS Section 422.  This is crucial to understanding when comparing ISO vs. NSO tax treatments.

Non-qualified Stock Options (NSOs)

With Non-Qualified Stock Options, things are more straightforward but less rosy tax-wise. NSOs don’t come with those particular tax advantages.

Instead, you’ll pay ordinary income tax on the profit (the ‘bargain element’) at exercise. The bargain element is the difference between the grant and market prices, not when they’re eventually sold. Ordinary income tax is almost always higher than capital gains.

However, on the bright side, if the value of your shares has gone up between the time you were granted them and when you exercised them, you do not immediately have a tax liability, unlike ISOs, which could be subject to AMT.

You only owe taxes on any additional gains made when selling your stock, paying the capital gains tax rates. So, there are still benefits with NSOs regarding capital gains vs. ordinary income tax treatment.

NSOs don’t have the same restrictions as ISOs and are generally open to contractors, advisors, and other folks beyond employees. This makes them a flexible option for companies.

Understanding ISO vs NSO: A Table Summary

Here’s a table summarizing the key differences between ISO vs. NSO:

Feature	Incentive Stock Options (ISO)	Non-Qualified Stock Options (NSO)
Eligibility	Typically employees only	Employees, contractors, advisors, and others
Taxation at Exercise	Not taxed at exercise, potentially subject to AMT	Taxed on the “bargain element” at the ordinary income tax rate
Taxation at Sale	Taxed at capital gains rates if holding periods are met	Taxed at capital gains rates
Holding Period for Preferential Tax Treatment	More than two years from the grant date AND More than one year after exercising the ISO	None
$100k Limit	Yes	No

FAQs About ISO vs NSO

Here are some answers to common questions about qualifying dispositions:

Which is better: ISO or NSO?

Unfortunately, there is no one correct answer regarding whether ISOs or NSOs are better. It depends on your individual situation.

However, knowing if you prefer the possibility of favorable tax treatment vs. less tax risk (and less potential upside) might sway you. Ultimately, it’s smart to loop in a tax pro at Dimov Tax to help determine which option best aligns with your financial goals.

What is the difference between ISO and NSO Carta?

Some companies use Carta as a software platform to manage equity. The tax treatment for Incentive Stock Options and Non-qualified Stock Options doesn’t change if a company uses Carta.

Is NSO the same as ISO?

No. While they are both employee stock options, the main difference between ISOs and NSOs is that ISOs can potentially get favorable tax treatment, while NSOs do not.

Why are ISOs better?

Whether ISOs are better than NSOs depends on several factors. If certain requirements are met, ISOs can potentially result in substantial tax savings. 

With NSOs, the tax treatment is more straightforward but generally less beneficial. If taxes are your priority and you meet certain holding period conditions and other IRS requirements, ISOs are usually better. However, NSOs are more flexible since they don’t have these restrictions. 

Final Thoughts

The battle of ISO vs. NSO doesn’t have to be confusing. The key is to approach this with a clear understanding of these options.

Keep in mind that we’ve presented these nuances in simplified terms. Taxes can be a bear to navigate on your own. 

As always, it’s best to consult the international tax professionals at Dimov Tax to determine which option best suits your circumstances and make the most brilliant move for your financial