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The Practical Tech Lawyer:  ISOs and NQSOs - What's the Difference?

In the United States, the federal tax code recognizes two types of stock options.  Section 422 of the Internal Revenue Code lays out the requirements for a stock option to qualify as an "incentive stock option," widely called an "ISO," which carries a tax benefit.  All other options are designated as "non-qualified" stock options, widely called "NQSOs."

In my next blog entry ("How are stock options taxed?"), I will describe how the tax advantage for ISOs works.  For the rest of this entry, I'll simply explain what it takes to qualify as an ISO.

First, ISOs are only available to employees of the company.  Consultants cannot get them.  Even members of your board of directors (unless also employees) cannot get them.

The exercise price of an ISO must be 100% or more of the fair market value of the underlying stock on the grant date.  For someone who owns 10% or more of the company's outstanding equity, the exercise price of an ISO must be 110% or more of the fair market value of the underlying stock on the grant date.

The option must be held for at least one year from the grant date, and after exercise the underlying stock must be held for at least another full year.

Only $100,000 of total ISOs held by each employee may vest in any year.  How is the $100,000 measured? Very crudely, I think -- you just multiply the number of option shares by th exercise price.  Consider this for example to understand how it works:  a stock option for 400,000 shares vesting in four equal annual installments (that is, 100,000 shares per year) with an exercise price of $3.00 per share would be three times too large ($300,000 per year) for all of it to qualify as an ISO.  The U.S. tax code would treat this as the award of an ISO for one third of the total, 133,333 shares, with the same vesting schedule and exercise price (33,333 shares vesting per year multiplied by $3.00) and a NQSO for the remaining 266,667 shares.  In order to prevent confusion and bad tax planning by the holder of that option, the company should do him the favor of creating two separate option agreements so that the distinction is clear.

An ISO is not transferable except by will or the laws of descent and distribution.

Finally, the incentive plan under which an ISO is awarded must be approved by the company's stockholders and cannot have a lifespan of more than 10 years.  ISOs themselves also must terminate within 10 years after their grant date.  For an ISO recipient who owns 10% or more of the company's outstanding equity, the ISO must terminate within 5 years after the grant date.

If your stock option satisfies all of these requirements, its holder is eligible for special ISO tax treatment.  But as we will see in the following blog entry, the one-year holding period for the stock after an ISO is exercised makes ISO taxation a fairly rare event.

Page 2: Non-Qualified Stock Options