How companies decide between incentive and nonqualified stock options

This article, originally published Oct. 31, 2022, has been updated to refine technical details and provide examples.

Stock options are a common form of equity compensation that give employees the right to buy company stock at a set price. Two of the most widely used structures are incentive stock options (ISOs) and nonqualified stock options (NSOs). While both can help align employee and company interests, they differ in eligibility rules, tax treatment and administrative requirements—differences employers should understand before designing or revising a stock option plan.

Stock options tend to be an effective compensation tool for two primary reasons: Employees must invest their own capital to exercise options, which reinforces their long term commitment to the company. And options generally provide value only if the company’s stock price increases, encouraging employees to focus on enhancing overall business value.

Although ISOs and NSOs both grant the right to purchase stock over time at a fixed price and result in share ownership upon exercise, the practical and tax consequences for employers and option holders can differ significantly. Understanding these differences is key to making informed decisions about equity compensation strategy.

Structure of incentive stock options and nonqualified stock options

ISOs must meet strict statutory requirements that limit who can receive them, how they are priced and when they can be exercised. Specifically, they must meet all the following requirements under section 422:

1. The options must be granted to employees.
2. The options must be granted in accordance with a written plan that (a) is approved by a formal vote of shareholders within 12 months before or after the plan’s effective date; (b) includes the aggregate number of shares available to be granted; and (c) includes the employees or class of employees eligible to receive options.
3. The options must be granted within 10 years after the plan is adopted or the plan is approved by shareholders, whichever is earlier.
4. The exercise price must not be less than the fair market value (FMV) of the stock on the date of grant (but see No. 6 below).
5. The term of the options must not exceed 10 years after the date of grant (but see No. 6 below).
6. Options granted to a shareholder who owns 10% or more of the total combined voting stock of the company (or its parent or subsidiary) must have an exercise price of at least 110% of the FMV on the date of grant, and the term of the options must not exceed five years.
7. The options must not be transferable except upon death.
8. The options must be exercised while the employee is still employed or within three months of termination of employment (12 months if the termination is the result of death or disability).
9. A $100,000 limit applies to the aggregate FMV—determined as of the grant date—of stock underlying the options that an employee can first exercise in any given calendar year. In the case of multiple grants, this limitation is absorbed in the order the options were granted.

An ISO that does not meet one or more of the above requirements or exceeds the $100,000 limit is automatically an NSO. (See also “Section 409A considerations” below.)

In evaluating which type of options to grant, the employer must first identify whether any of the ISO requirements are problematic from a business perspective. If so, NSOs may be a more appropriate choice. In fact, most option grants are structured as NSOs for their added flexibility.

If the company is amenable to the above ISO requirements, the next factor to consider is differences in tax treatment.

Tax treatment of ISOs for employers and employees

The tax treatment of ISOs is generally more favorable for employees, but it comes with trade offs for employers and additional compliance requirements. The following tax consequences arise from a qualifying disposition:

For employees:

• No income is reportable or includable in gross income of the employee at the time of grant. (See section 421 (a)(1).)
• No income is reportable or includable in the employee’s gross income upon exercise of the options, except as noted below regarding the alternative minimum tax (AMT).
• The difference between the exercise price and the FMV of the stock at the time of exercise (i.e., the spread) could subject the employee to the AMT.
• The employee’s basis in the ISO stock is equal to the amount paid upon exercise of the options. (See section 421(c)(3)(A).)
• The holding period of the stock begins on the date of exercise.
• If the stock received upon exercise of the ISO is held until the later of 1) two years after the ISO grant date, or 2) one year after the exercise date, the sale is a qualifying disposition, resulting in long-term capital gain or loss.

For employers:

• The employer is not entitled to an income tax deduction at the time of grant or exercise. (See section 421(a)(2).)
• There is no compensation income from a qualifying disposition and therefore nothing to report on Form W-2, Box 1 (Wage and Tax Statement), or to treat as wages subject to income tax withholding or payroll taxes (i.e., taxes under the Federal Insurance Contributions Act (FICA); see also “Tax withholding issues” below).
• The employer is required to provide an information statement on Form 3921 (Exercise of an Incentive Stock Option Under Section 422(b)) to the employee exercising the ISOs by Jan. 31 of the year following the exercise.
• The employer must file Form 3921 with the IRS to report each ISO exercised during the preceding calendar year. The filing is due by Feb. 28 if filed on paper or by March 31 if filed electronically. Electronic filing is required when the employer files 10 or more information returns in the aggregate during the calendar year.

If the stock received upon exercise of the ISO is disposed of before the later of 1) two years after the ISO grant date, or 2) one year after the exercise date, the sale is treated as a disqualifying disposition.

The following tax consequences arise from a disqualifying disposition.

For employees:

• The difference between the exercise price and the FMV of the stock on the date of exercise is considered ordinary income to the employee in the year of disposition. However, if the value received upon disposition is less than the FMV on the date of exercise, the ordinary income is limited to the difference between the disposition price and the exercise price of the ISO stock. (See section 422(c)(2).)
• This income is taxable in the year of the disposition of the stock. However, certain transfers of stock may not be considered dispositions for this purpose (e.g., the exchange of the ISO stock in a tax-free merger or reorganization transaction, a transfer due to a divorce, a transfer from a decedent to his or her estate, or a transfer by bequest).
• The employee’s basis in the ISO stock is equal to the amount paid upon exercise of the options plus the amount taxable as ordinary income due to such a disposition.

For employers:

• The employer must report the applicable compensation income on Form W-2, Box 1, issued to the employee, for the year of disposition. This allows the employer to take a tax deduction for the same amount.
• The income from a disqualifying disposition is not considered wages subject to income tax withholding or FICA taxes. (See also “Tax withholding issues” below).

Tax treatment of nonqualified stock options (NSOs) for employees and employers

Unlike ISOs, NSOs generally trigger taxable compensation income at exercise, but they also allow employers to claim a corresponding tax deduction.

For employees or independent contractors:

• No income is reportable or includable at the time of grant (assuming the options do not have a readily ascertainable FMV, which they almost never do unless they are traded on an exchange).
• The option holder must recognize ordinary income upon exercise of the NSO equal to the difference between the exercise price and the FMV of the stock on the date of exercise (i.e., the spread).
• The tax basis of the stock received upon exercise is equal to the FMV of the stock on the date of exercise. Effectively, the employee or independent contractor’s basis equals the exercise price paid plus the ordinary income recognized upon exercise.
• The holding period for the stock begins on the date of exercise.
• A subsequent sale of the stock should be eligible for long-term capital gain or loss treatment if the stock is held for more than one year after the date of exercise.

For employers:

• The employer receives an income tax deduction for the wages recognized by an employee (or income recognized by an independent contractor) with respect to the NSO exercise.
• This value spread at the time of exercise is treated as wages for income tax and FICA tax reporting and withholding purposes with respect to an exercising employee. Box 12 should use code V and provide the compensation amount related to the NSO exercise.
• Wage withholding and reporting do not apply to the exercise of NSOs by an independent contractor.

Section 409A considerations for ISOs and NSOs

Section 409A is intended to prevent deferral of compensation without proper restrictions, and when it applies to stock options, the tax consequences can be significant.

Section 409A can result in adverse tax treatment if it applies to an option grant and the option terms do not comply with its requirements. Section 409A does not apply to option grants that qualify as ISOs.

Further, under the stock rights exclusion, section 409A does not apply to NSOs provided they satisfy all the following requirements:

• The exercise price of the options may never be less than the FMV of the stock on the date of grant.
• The underlying stock must generally be common stock of the employer or of a parent company that owns 80% of the employer.
• The number of shares subject to the NSO must be fixed on the date of grant.
• The options must not contain any feature that defers the taxation of the NSO income beyond the later of 1) the exercise date, or 2) the date the stock received upon exercise is no longer subject to a substantial risk of forfeiture.
• The options must be taxable in accordance with section 83.

Most NSOs are designed to meet these requirements and avoid the application (and potential adverse tax treatment) of section 409A.

Most notably, adherence to the stock rights exclusion requirements means that the NSOs must not be granted at a discount (i.e., at an exercise price lower than the FMV of the stock at grant). Thus, an employer must determine its stock price, and option grants must contain an exercise price at least equal to the grant date FMV.

If an employer intends to grant NSOs at a discount, the options can be structured to comply with the requirements of section 409A. However, this would require significant restrictions on the exercisability of the options.

The NSOs would not be exercisable at the discretion of the option holder and would be restricted to payment events permitted under section 409A. (See section 409A-compliant stock options for more information on technical issues.)

NSOs that are subject to section 409A and fail to meet those requirements result in taxable income to the option holder as of the date the options vest, regardless of whether the options have been exercised. The amount of income equals the inherent appreciation in the options as measured on each Dec. 31, beginning with the year of vesting and continuing each year thereafter until the options are finally exercised.

In addition to paying tax on this phantom income, the option holder may have to pay an additional 20% tax and a premium interest tax due to the section 409A failure. These taxes are in addition to the regular income tax.

The employer also has potential exposure in that it is required to report the section 409A failure and to collect and remit applicable income tax withholding at the time the section 409A income is triggered. Failure to do so exposes the employer to penalties.

To avoid significant adverse tax consequences, option grants should be structured either to qualify for the section 409A stock rights exclusion or, if that isn’t feasible, to comply with section 409A.

Tax withholding issues related to ISOs and NSOs

Income from an ISO plan is not treated as wages for payroll tax purposes, while income from an NSO plan is.

Payroll tax is the general term for taxes under FICA, which include the Old-Age, Survivors and Disability Insurance (OASDI) tax—also known as the Social Security tax—and the hospital insurance tax, or Medicare tax.

Therefore, NSO plans require both the employer and the employee to pay payroll taxes on NSO exercises, including the 1.45% Medicare tax and the 6.2% Social Security tax (subject to the wage cap on the Social Security tax portion and a potential additional 0.9% Medicare tax for the employee). Generally, however, the cost of these payroll taxes is more than offset by the NSO exercise-related income tax deduction.

An employer must address how to handle the tax withholding obligations of NSOs. Although the exercise of a stock option is generally not a cash transaction, the government requires the withholding to be made in cash—that is, the company transfers stock to the employee, but the employee owes income tax withholding and their share of payroll tax in cash.

Often, as a condition of exercise, option plans require that the employee pay the employer the cash amount needed to cover the income and payroll withholding tax obligations together with the exercise price.

Alternatively, the employee and employer can agree that any required withholding taxes will be withheld from other wages payable to the employee or that the number of shares transferred upon the exercise will be reduced by the value of the withholding obligation.

In some cases, the employer may be willing to increase the benefit to offset the withholding costs. However, the increase itself will result in additional taxable wages.

Methods of exercise

A key element of both ISOs and NSOs is the method of exercise. Some stock option plans require the employee to pay the exercise price in cash, which may be difficult for employees who receive more of their compensation in stock than cash. For this reason, many option plans allow for cashless or net exercises.

Typically, a cashless exercise includes a sale of already-owned shares to cover the exercise price, or the use of a broker that would loan the exercise price (and potentially related taxes) and then immediately after exercise sell a portion of the option shares to cover the loan.

A net exercise operates similarly economically. However, it instead is a cancellation of a certain number of options to cover the exercise price (and potentially related taxes) rather than an affirmative payment of the exercise price.

It should be noted that a cashless exercise of ISOs can trigger a disqualifying disposition with respect to the shares used to cover the exercise price. This occurs when those shares are either already owned and have not met the holding-period requirements or are immediately sold after exercise under a broker sell-to-cover arrangement.

A net exercise of ISOs causes all ISOs to lose ISO status because the options are not exercised as required by the ISO rules.

Pros and cons of ISOs and NSOs for employers and employees

When evaluating ISOs versus NSOs, companies should consider more than tax treatment alone. Cash flow impact, payroll taxes, administrative complexity and talent retention objectives all play a role in determining which option structure best supports the business.

Incentive stock options (ISOs)

More favorable to the employee:

• Defer income recognition until the shares received upon exercise are disposed of
• Qualify for long-term capital gains rates if holding periods are met
• Avoid payroll taxes

Generally less favorable to the employer:

• Generally do not allow a tax deduction
• Are less flexible and more difficult to administer

Nonqualified stock options (NSOs)

More favorable to the employer:

• Allow a tax deduction
• Are more flexible and easier to administer
• Can be issued to independent contractors

Generally less favorable to the employee:

• Trigger compensation income equal to the spread at exercise
• Subject that income to payroll tax

For these reasons, ISOs are more common at startups that lack current taxable income and have the potential for substantial stock price appreciation.

Evaluating ISOs and NSOs with the help of a trusted advisor

ISOs and NSOs offer different advantages and limitations for employers designing equity compensation programs. 

While ISOs may provide more favorable tax treatment for employees, they come with stricter statutory requirements and less flexibility. NSOs, by contrast, offer greater administrative ease and employer tax deductions, but can result in taxable income and payroll taxes at exercise. Because these trade-offs can affect cash flow, compliance obligations and talent strategy, effective stock option design depends on each company’s objectives, facts and circumstances.

An experienced advisor can help companies evaluate how different option structures align with their tax position, growth plans and compensation objectives, as well as identify potential compliance risks tied to areas such as payroll tax withholding and section 409A. Reviewing option plans and grant terms before implementation can help ensure the structure supports both near term operational needs and longer term business goals.