Dun & Bradstreet Small Business - Dun & Bradstreet Credibility Corp
navigation background image right
 
 
 
 

Understanding Employee Stock Options: ISOs and NSOs

Some companies offer stock options as a means of letting their employees take a vested interest in the business while reaping the rewards of its success. Two common plans are incentive stock options and nonstatutory stock options, also known as nonqualified stock options. Here’s a look at stock options and the differences between ISOs and NSOs.

A stock option is a financial instrument that gives employees the right to purchase shares in the company they work for, under conditions set by the employer. This can result in employees making money above and beyond their annual salaries or it can be a means for them to start a savings plan.

Stock options have a vesting schedule, outlined in the stock option agreement, that details the amount of time it takes for employees to become entitled to an increasing percentage of their company stock options. Some companies offer new employees immediate vesting as a type of sign-on bonus. Others structure their plans so that options vest over a period of years, creating an incentive for employees to remain with the company. Still other businesses reward employees for hard work through performance-based stock option plans that vest incrementally when certain performance goals are met.

Ideally a company awards the option to buy company stock some time in the future at the price it is selling at the time. The assumption is that the company will be successful and the price will go up in the future. The current price is called the exercise price.

Let's say that after one year an employee decides to exercise his or her option to buy the company's stock. If the exercise price of the stock was $20 a share when the employee received the option and the stock is now selling at $25 a share, that $5 difference is called the spread.

The key difference between ISOs and NSOs is the way in which the spread is taxed. ISOs offer the possibility of being taxed under long-term capital gains (if the employee holds the stock for at least two years from the date the option was granted and at least one year from the exercise date), whereas NSOs are taxed as both income and capital gains. With NSOs, the spread is viewed as income and is treated as compensation, which is taxed at a higher rate. With ISOs, the tax is deferred and they are taxed as long-term capital gains when the stock is sold, providing the employee follows the rules as set down in the tax code.

There’s one big catch to the seemingly rosy ISO tax scenario. Exercising ISOs can trigger the alternative minimum tax. A large spread alone can result in AMT payment, while in some instances, exercising ISOs will have no AMT consequence at all.

The following compares ISOs and NSOs.

ISOs

  • Employees don't have to report any income when they exercise the stock option, unless they sell the stock soon after they buy it.
  • Holding the stock for a period of time ensures that the profit will be treated as long-term capital gains, meaning the seller can qualify for the 15 percent maximum rate.
  • Because ISOs must conform to section 422 of the tax code, they must follow certain guidelines that NSOs are exempt from.
  • ISOs may trigger the AMT.
  • Only employees may be granted ISOs.

NSOs

  • Employees must report their taxable income when they exercise the option to buy stock.
  • The income is treated as compensation, resulting in higher taxes.
  • NSOs have fewer regulations and restrictions than ISOs.

Related Content

Selling Your Company to Your Employees
When selling a business, owners often neglect to look around them for prospective buyers.
article
What Are Health Savings Accounts?
HSAs can be useful in supplying your employees (and yourself) with health insurance. Learn more about this valuable...
article
Key Compensation Components
Compensation has become a far more complicated issue than just deciding how much to pay your employees.
article
Limited Liability Company (LLC) Basics
If you want your business to have the flexibility and tax advantages of a partnership while maintaining the...
article
Selling Your Business Using Installment Sales and Earnouts
If you are planning on selling your business, you have more options than ever before. One increasingly popular...
article
Tax Issues to Consider Before Selling a Business
The government views the income you receive on the sale of your business as either personal income or...
article
Recordkeeping for Barter Transactions
Barter transactions are taxable events, which means you need to have proper recordkeeping tools in place.
article
How to Choose a Managed Care Plan for Your Company
Most small businesses will choose between two types of managed care plans — health maintenance organizations (HMOs) and...
article
How Many Health Insurance Options Do Employees Really Need?
Two health insurance options are usually sufficient for most start-up organizations. Give employees a choice between a health...
article
Employee Benefits
The educated American work force has come to expect a comprehensive benefits program; the absence or inadequacy of...
article
What Employee Benefits Are Mandatory?
Believe it or not, the only legally required benefit employers are obligated to maintain is workers' compensation insurance...
article
Where Can I Get Information on Medical and Health Plans?
There are numerous online resources to help you find health care plans.
article
How to Choose a Health Care Plan
When selecting a health care plan, you need to focus on more than just the premium. The lowest...
article
Beefing Up Your Benefits Package
You know that employees today want the most comprehensive benefits package possible, but how exactly can you put...
article
How Much Can I Ask Employees to Pay for Insurance?
On average, small businesses pay 75 percent to 100 percent of the total insurance cost for their employees...
article
Where Can I Get Information on Dental Plans for Small Businesses?
Discover some helpful online resources to help find the best affordable dental plan for your employees.
article
Health Purchasing Alliances and Association Plans
For small businesses in need of affordable health insurance, purchasing alliances and association plans are alternatives to traditional...
article
Health Insurance Plans as a Competitive Advantage
The quality of your benefits package can make the difference between attracting star candidates and average performers.
article
Build Employee Loyalty with Alternative HR Benefits
Creative alternatives to standard HR benefits, such as flex schedules or free health club memberships, help keep employees...
article
Your Business Success Starts with a Happy Staff
Employees expect to be treated better by their employers, and the smart entrepreneur knows how to harness the...
blogpost
Business Name:
City (optional):
State:
Country:
My Business
Other Business
Related Products
1-877-753-1444
Mon-Fri 8am - 9pm ET
Resources & Tools
Email Us
Email us if you have any questions about our products, services or website. Or give us a call at 1-800-333-0505
Education Center Education Center
Running a small business and staying informed go hand in hand.
White Papers White Papers
Get insights from D&B and other knowledgeable sources.
Email Your Company's DUNS NumberD&B D-U-N-S® Number Search
Need to know your company's DUNS Number? Get it emailed to you.
D&B Credibility Review - Control what others see