In my experience at Scalar, I’ve had the opportunity to work with and value many startup companies. As I’ve consulted with companies, often I’m asked how an Incentive Stock Option (“ISO”) differs from a Non-qualified Stock Option (“NSO”). The short answer is that ISOs are issued to employees and may receive better tax treatment than NSOs, which are typically issued to advisors, directors, consultants, or contractors.
It’s all about the tax treatment. Recipients of ISOs do not have to pay taxes when they exercise their options (NSO holders do pay taxes at exercise) and receive favorable tax treatment when the underlying share is sold if they meet these qualifications:
Taxation of an ISO or NSO
Here is an example and infographic to further highlight the possible differences of taxes owed on an ISO and NSO.
A company issues an option on June 30, 2019 with a strike price of $1.00 (the strike price is equal to the FMV). One year later on July 1, 2020, the FMV of the underlying share has appreciated to $3.00, and the holder exercises her option. Another year passes and on July 2, 2021, the company is sold for a price of $5.00 per share.
In this simplified case, the holder would see ~14% higher earnings holding ISO vs NSO.
There is a third scenario that is common and potentially the least tax advantageous where the holder of an ISO is disqualified from the preferred ISO tax treatment because they don’t meet the three qualifying requirements. For example, using the same details as above, except instead of the employee exercising the options on July 1, 2020, they wait until the company is sold at $5.00 per share. That means they did not exercise their options and hold the shares for 1 year prior to selling the shares, which could result in the ISO holder owing more taxes than an NSO holder. See the appendix for a table with the calculations.
Other Important Characteristics of an ISO or NSO
ISO/NSO: Both options will have an expiration date set by the employer.
ISO: If an ISO holder tries to exercise more than $100,000 worth of ISOs in one year (strike price multiplied by the number of options being exercised) the surplus will be treated as NSOs, thus triggering additional tax liabilities.
Receiving an ISO can provide an employee with the option to receive the most advantageous tax treatment. Also, for those receiving stock options, either ISOs or NSOs, it is more complex than it appears to be on the surface. It’s important for an employee that is receiving an ISO to consult with a professional to maximize the value that ISOs can provide.
How can Scalar help? Scalar values companies to determine the fair market value of their shares through a 409A valuation. This allows a company to set the strike price for options. The 409A valuation is a crucial part of the process whether a company is issuing options, employees are exercising options, or employees are selling their shares. In each of these events, it’s necessary for a company to know the FMV of its shares to help mitigate potential tax penalties or additional tax liabilities for itself and its employees.
Due to the everchanging and complex nature of tax regulation surrounding granting options, exercising options, and selling shares, please consult with your attorney, tax professionals, or auditors. This article is purely informative, and Scalar does not accept any responsibility for action taken based on the content of this article.
 – Internal Revenue Code Section 422. https://www.law.cornell.edu/uscode/text/26/422