By: Jon Avidor
Companies planning to offer options of its stock as a form of compensation generally have two choices: an incentive stock option (ISO) plan, or a nonqualified stock option (NQSO) plan. The most notable differences between ISOs and NQSOs are in their tax treatment and the advantages they provide to employers and its recipients.
ISOs can only be offered to employees. ISOs are offered an incentive for personnel to remain with a company over a long period of time and to work to increase the company’s value. With an equity option in the company, the better the company does, the more the employee’s equity will be worth. Generally, ISOs are more beneficial for employees than NQSOs for tax reasons: employees can defer recognition of income until either the grant or exercise of the shares, and the income gained via disposition of the shares is taxed more favorably as long-term capital gain.
ISOs provide a slight benefit to employers in that they are exempt from 409A valuation, with some considerations. However, ISOs offer less benefits for employers than NQSOs. Employers are generally not entitled to tax reductions for ISOs, and ISOs come with complex administrative rules; companies must also comply with a long list of requirements to be eligible to offer an ISO plan. Nevertheless, ISOs may be an attractive option for start-ups whose stock may increase significantly later down the road as their business develops.
NQSOs are typically more favorable for the employer. NQSOs can be granted to both non-employees, including non-employee directors, consultants and advisors, and employees. Employers can claim a tax deduction for NQSOs and are more straightforward to administer. There are fewer tax minefields, as it is more straightforward to determine the taxes owed on NQSOs than ISOs. One caveat is that income from an ISO is not treated as wages for employment tax purposes, while income from an NQSO plan is, requiring both employer and employee to pay employment taxes on NQSO plan payments. However, the NQSO tax deduction typically offsets this cost for the employer.
Employers should consider their unique business needs and weigh the benefits of both types of plans before utilizing options as a form of compensation.