Understanding Your Stock Options: ISO vs. NSO

Stock options give you the right, but not the obligation, to buy company shares at a set price (the exercise price or strike price) sometime in the future. Think of it like a coupon for your company’s stock. There are two main types of stock options: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). Both can be valuable, but they have different tax implications. Let’s break down the key differences.

ISO (Incentive Stock Option)

• Tax Benefits: ISOs offer potentially favorable tax treatment. If you hold the shares you purchase through your ISO for a certain period (more on this below!), any profit you make when you sell them could be taxed at the lower capital gains tax rate, rather than your ordinary income tax rate. This can translate to significant savings.

• Qualifying Dispositions: To get the preferential tax treatment, you must meet certain holding period requirements. Specifically, you must hold the shares you purchase through exercising your ISO for at least two years from the grant date (when the options were given to you) and one year from the exercise date (when you bought the shares). If you don’t meet these holding requirements, the sale is considered a “disqualifying disposition,” and the profit will be taxed as ordinary income. There’s also a potential Alternative Minimum Tax (AMT) implication when you exercise ISOs—see our page on Alternative Minimum Tax (AMT) for details.

• Eligibility: ISOs are typically only available to employees.

NSO (Non-Qualified Stock Option)

• Taxation: NSOs are taxed as ordinary income on the difference between the market price at the time of exercise and your exercise price. This tax is due when you exercise the options, even if you don’t sell the shares immediately.

• No Holding Period Requirements: Unlike ISOs, there are no required holding periods to worry about with NSOs. You can sell the shares anytime after exercise.

• Wider Eligibility: NSOs can be granted to employees, advisors, and consultants.

Comparing ISOs and NSOs

Feature	ISO	NSO
Tax Treatment	Potential for capital gains tax	Ordinary income tax
Holding Period	Required for favorable tax treatment	None
Eligibility	Employees only	Employees, advisors, consultants

Which is Better?

There’s no one-size-fits-all answer. The best choice depends on your individual financial situation and tax bracket. Consider factors like your company’s expected growth, your personal financial goals, and how long you plan to hold the shares. Consulting with a tax advisor is always recommended to make informed decisions about your stock options.

So here’s what we covered:

• Definitions of ISOs and NSOs
• Tax implications of each type of option
• Eligibility requirements
• Key differences between ISOs and NSOs
• Factors to consider when deciding which type of option is better for you

(Learn more about Exercising Your Stock Options) (Learn more about Understanding Your Shareholder Agreement) (Learn more about Tax Basis: Calculating Your Cost)