{"id":12212,"date":"2023-06-08T14:33:41","date_gmt":"2023-06-08T19:33:41","guid":{"rendered":"https:\/\/financialdesignstudio.com\/?p=12212"},"modified":"2023-08-10T09:42:40","modified_gmt":"2023-08-10T14:42:40","slug":"nqsos-versus-isos-whats-the-difference","status":"publish","type":"post","link":"https:\/\/financialdesignstudio.com\/nqsos-versus-isos-whats-the-difference\/","title":{"rendered":"NQSOs versus ISOs: What’s the Difference?"},"content":{"rendered":"
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\"Experienced<\/figure><\/div>\n\n\n

Stock options can be one of the most valuable forms of executive compensation. They can also be the trickiest to manage when it comes to taxes. There are two flavors of stock options. These are offered to executives at private and public companies: Non-qualified Stock Options (\u201cNQSOs\u201d) and Incentive Stock Options (\u201cISOs\u201d). Each has their own tax rules to follow, and careful planning is imperative, especially if you\u2019re a high-income earner. In this post we\u2019ll explore the topic, NQSOs and ISOs, What\u2019s the Difference?<\/p>\n\n\n\n

Stock Option Basics<\/strong><\/strong><\/h2>\n\n\n\n

Before discovering the differences between NQSOs and ISOs, let\u2019s first look at what they have in common with each other. The concept of how stock options work is like that of another form of compensation, Restricted Stock Units (\u201cRSUs\u201d)<\/a>. There are three key stages for both types of options and for RSUs.<\/p>\n\n\n\n

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Stage 1: Granting of stock options<\/strong><\/h3>\n\n\n\n

Regardless of which type of option you\u2019ve been granted – NQSOs or ISOs – the granting stage is the same. The company wants to reward you to work hard and stay with the company for a long time. Giving you stock options is a way to do that. As the value of an option increases as the value of the company increases.<\/p>\n\n\n\n

There\u2019s nothing for you to do when you\u2019re granted stock options, as they won\u2019t have value until you earn them. But keeping track of the options they have granted you helps you plan for the future.<\/p>\n\n\n\n

Stage 2: Vesting of stock options<\/strong><\/h3>\n\n\n\n

The value of stock options won\u2019t become real for you until the options \u201cvest.\u201d This is a fancy way of saying you have to do certain things to earn the options. <\/p>\n\n\n\n

The most common way to vest stock options is time-based. For example, your company might say that you have to work for them for at least 3 years in order to fully earn your stock option grant. Each year, you earn a portion of the options that were granted to you, as shown below.<\/p>\n\n\n\n

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Make sure you understand how your company\u2019s option vesting schedule works, as it may differ from the example above.<\/p>\n\n\n\n

Stage 3: Exercise & Invest stock options<\/strong><\/h3>\n\n\n\n

The final stage that\u2019s common between both types of stock options is the \u201cinvest\u201d stage. This is where you make a conscious decision to exercise your options and start owning stock in your company.<\/p>\n\n\n\n

The most important consideration when exercising stock options is to realize that you need to pay cash for the shares you exercise! For example, if you are exercising 1,000 options with an exercise price of $10\/share, you need to come up with $10,000 cash to pay for the purchase of those shares.<\/p>\n\n\n\n

That can be a big hurdle for many employees. Fortunately, if you work for a publicly traded company, you can likely sell some shares to cover the cost of the exercise and any taxes you may owe. This is called a \u201ccashless exercise\u201d or \u201csell to cover\u201d strategy. Many brokers will take care of this for you when you exercise shares. You\u2019ll receive a \u201cnet\u201d amount of shares less the cost of exercise and taxes.<\/p>\n\n\n\n

However, if you work for a privately held company, exercising stock options is more complicated. In most cases, you\u2019re not allowed to sell shares you exercise because the company is not publicly traded. Hence, you\u2019ll need to consider the cash flow needed to exercise shares in a privately held company before you do it.<\/p>\n\n\n\n

What are Nonqualified Stock Options?<\/strong><\/h2>\n\n\n\n

Nonqualified stock options (\u201cNQSOs\u201d) are the most common form of stock options given to employees. You can learn more about them in our video on NQSOs<\/a>. They\u2019re most popular with publicly traded companies and offered to many executives at these companies.<\/p>\n\n\n\n

Why are these options called ‘nonqualified’? It\u2019s a tax term meaning that the IRS doesn\u2019t give these types of options any special tax treatment. We\u2019ll get into how taxes work with NQSOs below.<\/p>\n\n\n\n

Finally, there\u2019s no limit to how many NQSOs your company can grant to you. They can grant you as much – or as little – as they want. <\/p>\n\n\n\n

What are Incentive Stock Options?<\/strong><\/h2>\n\n\n\n

Incentive stock options (\u201cISOs\u201d) are a special type of stock option that enjoys special tax advantages if done correctly. You can watch our video on ISOs<\/a> to learn more! ISOs are a popular form of compensation for early stage, non-public companies. They offer employees a turbo-charged way to get tax-favored exposure to their company\u2019s future growth. Which can become quite valuable if the company goes public in an Initial Public Offering (\u201cIPO\u201d).<\/p>\n\n\n\n

Unlike NQSOs, the IRS applies a $100,000 limit to the value of ISOs that qualify for favorable tax treatment. The limit applies to each calendar year and is based on the value of ISO grants that vest that year. Here\u2019s an example of how this limit works.<\/p>\n\n\n\n

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This employee received an increasing amount of grants for three years. It\u2019s okay that in Year 2 and Year 3 they received grants worth more than $100,000. This is because the grants vest equally over three years, so the entire amount doesn\u2019t vest at once.<\/p>\n\n\n\n

However, in the third year, we can see that the total value of vesting grants from Year 1, 2, and 3 equals $120,000, more than the IRS limit. What happens? The first $100,000 of vesting ISOs will get favorable ISO tax treatment, but the IRS will treat the remaining $20,000 as NQSOs, which are less tax favorable.<\/p>\n\n\n\n

Both ISOs and NQSOs offer the potential to build substantial wealth in your employer stock. They\u2019re granted similarly and vest similarly. But the tax treatment is different.<\/p>\n\n\n\n

Tax Treatment of Nonqualified Stock Options (NQSOs)<\/strong><\/h2>\n\n\n\n

The mechanics of NQSO taxation is like that of Restricted Stock Units (\u201cRSUs\u201d)<\/a>. The major difference between NQSO and RSU tax recognition is that you have more control over when<\/em> you realize taxes with NQSOs.<\/p>\n\n\n\n

You realize taxes on NQSOs when you exercise the options. You get to choose when you exercise NQSOs, as long as it\u2019s before they expire. These are the key things to know about NQSOs and taxes.<\/p>\n\n\n\n