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Not So Obvious: Here's What To Know Between NSO and ISO Stock Options

Nat Disston | May 18, 2017


The world of startup stock options can be pretty opaque. To outsiders, its seems all one does is join a small company, and, if it works, everyone becomes millionaires. For new employees, they often don’t know what they don’t know and are faced with piles of new documents and more questions once they join their budding business. Core to our mission is to help educate employees, companies, and their founders about their stock options and what they can do with their resulting shares.

We’ve had the good fortune of an engaged community of readers and this post is a direct response to a reader request. If you have anything you’d like to see discussed on these pages, please let us know! Here, we dive into a common point of confusion around ISOs (Incentive Stock Options) and NSOs (Non-Qualified Stock Options). But first…

What the heck is a stock option?

A stock option is a right to purchase a share of stock at a specific price within a specified period. Stock options are often used as long term incentive compensation for management and employees at high-growth companies. Once an employee exercises (buys) their stock options, they become stock in the underlying company. More on that here.

So back to the ISOs and NSOs. What drives the main point of confusion? You may have heard some discussion at the watercooler/ping-pong table that “ISOs have better tax treatment.” But with the labyrinthine American tax code, let’s circle above this topic at a few thousand feet.

Do ISOs really have better tax treatment? Maybe, but it’s not so black and white. ISOs are complicated because they can only be issued to employees (and not to contractors, lawyers, or outside vendors), must be priced at Fair Market Value (FMV, which is the same as a 409A valuation), and there are limits on how they vest and how much can vest in a given year (up to $100K). NSOs can be granted to anyone with no limit on volume or exercise price.

But Nat…which ones do I want???

(Disclaimer: I’m no tax expert and must advise you to speak to an accountant or financial advisor regarding your own situation.) NSOs are straight forward in that you must pay ordinary income tax on any gains at the time of exercise. If the current FMV is now $5 and your exercise price is $1 (FMV at time of grant), you pay ordinary income on the $4 paper gain. Furthermore, this tax event is withheld by your employer and may be tax deductible for them: another win for your employer. ISOs, on the other hand, don’t have any required tax at the time of exercise, which sounds nice but can be misleading. The fact is that exercising ISOs may make you subject to the AMT (Alternative Minimum Tax), which for most startup employees will be the case, and can lead to quite a surprise come tax season. Kind of like a club that has no cover charge at the door, but sells you $20 beers.

Still with me? We’re almost done! Remember: taxes are boring, but your taxes are important.

A commonality between NSOs and ISOs is that you will owe taxes when you exercise either type of options. Once the options are exercised, however, they are perfectly equal – stock in your company. This is important to note for EquityZen’s business, because they are treated the same way on the secondary market.

Conclusion

NSOs and ISOs differ in how they are taxed. And while there may be instances that ISOs have better tax treatment, each case is a little bit different. Fun Fact: a large part of EquityZen’s business is helping employees cover their exercise cost and subsequent tax bill, regardless of whether they’ve exercised ISOs or NSOs.


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