Incentive Stock Options (“ISOs”) and Non-qualified Stock Options (“NSOs”) are both types of stock options that service providers can receive under a company’s stock plan. They differ in the tax treatment applicable (both to the recipient and to the company) and the persons who are eligible to receive such options.
ISOs are only issuable to current employees and are eligible to receive potentially favorable tax treatment if the shares issuable upon exercise of the ISO are held (and not sold) until the later of (a) 1 year from the date the option is exercised, and (b) 2 years from the date the option is granted. This is referred to as the “ISO Holding Period”. When ISO shares are sold before satisfying the ISO Holding Period, it is called a "disqualifying disposition" (i.e., you are disqualified from receiving the favorable tax treatment). Employees can only receive a total of $100,000 worth of ISO shares (based on exercise price) that become exercisable for the first time in any calendar year. Upon exercise, there is generally no regular income tax on ISOs. However, the exercise of an ISO may subject the optionee to the alternative minimum tax (“AMT”). In computing AMT income, shares purchased upon exercise of an ISO are treated as if they had been acquired by the optionee pursuant to an NSO (i.e., the spread between the shares’ fair market value and exercise price at the time of exercise is an AMT adjustment item that is added to the optionee's AMT income for the year).
NSOs are any options granted in excess of the $100K ISO limit (set forth above) or any options granted as ISOs. Upon exercise of an NSO, the optionee is taxed at ordinary income tax rates on the excess, if any, of the fair market value of the shares on the date of exercise over the exercise price (the “spread”). If the optionee is an employee, the company must withhold applicable income, employment and other taxes at the time of exercise on the spread.