Everyone who works at a startup wants their stock options, and they want the good kind – incentive stock options (ISOs). Why? ISOs offer two distinct tax advantages over their less popular sibling, nonstatutory stock options (NSOs). First, the taxable event for an ISO is later than for an NSO. NSO holders have to pay income tax when they exercise, but ISO holders do not have to pay until they sell the underlying stock, as long as they meet the holding period requirements (see below). Second, the tax rate that ISO holders pay is lower. NSO holders have to pay ordinary income tax on the difference between the strike price and the fair market value upon exercise, whereas ISO holders are subject to the lower capital gains rate on the difference between the purchase price and the sale price.
ISOs have a number of requirements. Only employees may get ISOs. Also, ISO holders have to hold on to their shares for the required holding period (1 year from exercise, 2 years from option grant date). In most cases, ISOs have to be exercised less than three months after the termination of employment. Also, the exercise price must be at or above the fair market value of the stock on the grant date. If any of the ISO requirements are not met, ISOs will be treated as NSOs.
ISO holders should note that they may still be subject to the alternative minimum tax (AMT) in the year that they exercise their options, and depending on the individual tax situation the AMT may significantly reduce the tax benefits of ISOs. If you have ISOs that you are thinking of exercising, you should consult your tax advisor on the potential AMT consequences.
Generally, however, ISOs are still an attractive form of equity for most. Just make sure that you’re aware of their requirements and implications.