Both Nonqualified Stock Options (NSOs) and Incentive Stock Options (ISOs) are acronyms that are used quite a bit in the technology compensation space. From a tax perspective, we can describe them as ISO – “I save on taxes” and NSO – “no savings on taxes.” Despite this, the advantages of NSOs can be lucrative.
Typically, NSOs are despised because they have a higher tax. You must pay ordinary income tax on them. However, there are ways to use them to your advantage. And they have features that can be more beneficial than ISOs, as long as you look at them outside of the immediate tax treatment.
The Advantages of NSOs
- Early exercise is easier
- No $100K annual limit
- No Alternative Minimum Tax (AMT)
Advantage #1 – Early Exercise
Let’s say you work at a great startup that has a lot of potential. You want to take advantage of buying some shares on the grant date so you can have a lot more upside in the future.
You can do this by exercising some options early. It’s best to do this with NSOs because you don’t have to worry about holding period issues (12 months from stock purchase / 24 months from grant) like you do with the ISO. In addition, the cost to early exercise is the same with NSOs and ISOs, and you need not worry about timelines that could complicate your tax picture.
Furthermore, by early exercising NSOs at grant, your exercise price equals the 409A value at the time, so no additional income tax is due. By early exercising the NSO grant and filing the 83(b), you start the holding period for long term capital gains and QSBS treatment at exercise.
If this were an ISO grant, the 83(b) filing doesn’t start the clock for the capital gains holding period. This timeline starts at the vesting date.
Benefit #2 – No Annual Limit
Furthermore, there is no $100K annual limit like there is with ISOs.
For example, if you have 50,000 ISOs and the fair market value of the company is $3.00 per share, the total amount of options is $150,000.
However, only $100,000 of the options will be ISOs in the calendar year. The remaining $50,000 will convert to NSOs. As you continue to work at the company and the value of the shares increase, the ISO/NSO overflow will likely continue.
Merit #3 – No AMT
Finally, there are no AMT concerns with NSOs! Sure, you have lower tax treatment with ISOs, but you could have an AMT bill from using them. Although you are paying a higher tax upfront with an NSO, you won’t have to worry about further complicated tax issues come April 15th.
Although scorned because of their tax treatment, NSOs are a great way to participate in the upside of your company. If you have questions on how to make the most of the advantages of NSOs, give me a call.