United States

Deciding between incentive and nonqualified stock options

Understanding the differences between ISOs and NSOs

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Stock option plans are a powerful equity compensation tool. By requiring an investment from participants, these plans can heighten employee commitment to the company. And by tying benefits to an increase in company stock price, they motivate participants to increase company value.

However, there are substantial differences between incentive stock option (ISO) and nonqualified stock option (NSO) plans. Choosing the right plan for your company hinges on understanding these differences and how each plan aligns with your circumstances and strategy.

Pros and cons for employers, employees

ISOs are generally more favorable to employees because:

  • ISOs allow the recipient to defer any recognition of income until the shares received upon exercise are ultimately disposed.
  • The income ultimately recognized is eligible for taxation at more favorable long-term capital gains rates.
  • ISOs avoid payroll taxes.

For the employer, however, ISOs are generally less favorable. Employers generally are not allowed a tax deduction for ISOs, and ISO plans are less flexible and more difficult to administer. For these reasons, ISOs are most commonly used by start-up companies that do not have taxable income and that have the potential for substantial appreciation in their stock price.

Conversely, NSOs are generally more favorable to the employer because employers are allowed a tax deduction for NSOs and NSO plans are more flexible and easier to administer. One caveat—income from an ISO plan is not treated as wages for employment tax purposes, while income from an NSO plan is. Therefore, employers must pay employment taxes on NSOs. However, those payments are generally more than offset by the NSO tax deduction.

Download our white paper for more detail on the differences between ISOs and NSOs and determine which plan is right for your company.

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