Non-qualified stock options (NQSOs) and incentive stock options (ISOs) are two types of stock options that are commonly offered to employees in the United States. Both types of options allow employees to purchase company stock at a discounted price, but there are some key differences between the two.
The main difference between NQSOs and ISOs is the way they are taxed. NQSOs are taxed as ordinary income when they are exercised, meaning that the employee will pay taxes on the difference between the exercise price and the fair market value of the stock at the time of exercise. In contrast, ISOs are taxed at the capital gains tax rate when they are sold, which is generally lower than the ordinary income tax rate.
Another key difference between NQSOs and ISOs is the way they are granted. NQSOs can be granted to any employee, including executives and other key employees. ISOs, on the other hand, can only be granted to employees who are not officers or directors of the company and who do not own more than 10% of the company’s stock. Additionally, ISOs have annual limits on the number of options that can be granted to an employee, which is not the case for NQSOs.
In terms of holding period, NQSOs do not have any holding period requirements, meaning that the employee can exercise and sell the stock as soon as the options vest. In contrast, ISOs have a holding period requirement that states that the employee must hold the stock for at least one year after the exercise date and two years after the grant date to receive the lower capital gains tax rate.
Another key difference between NQSOs and ISOs is that NQSOs do not receive special treatment when it comes to alternative minimum tax (AMT), while ISOs do. When an employee exercises ISOs, the difference between the exercise price and the fair market value is not included in the calculation of the AMT. This can be beneficial for employees who would otherwise be subject to the AMT.
In conclusion, NQSOs and ISOs are similar in that they both allow employees to purchase company stock at a discounted price. However, there are some key differences between the two types of options. NQSOs are taxed as ordinary income when they are exercised, while ISOs are taxed at the capital gains tax rate when they are sold. Additionally, ISOs have annual limits on the number of options that can be granted, have holding period requirements, and are subject to different treatment under the alternative minimum tax.