Stock Options: NQOs vs. ISOs

I have written a bunch of different posts over time on the different types of equity incentives a startup or emerging company can offer its workers. Below is a list of some of them.

What Type of Equity Incentive Should I Use?

What’s Better for an Equity Incentive–Restricted Stock or a Stock Option?

Incentive Stock Options vs. Nonqualified Stock Options

Top 6 Reasons to Grant NQOs Rather Than ISOs

LLC Compensatory Equity Awards: Difficult and Complex

ISOs or NQOs?

I still regularly get asked this question: Should I grant NQOs or ISOs?

One thing you have to remember if you are going to grant ISOs is that they are subject to more limitations and restrictions than NQOs, and their tax consequences are more complex and difficult to ascertain than the tax consequences of NQOs. In short, ISOs are more complex than NQOs. Thus, if you want to keep your life simpler, you would just choose to use NQOs so that you don’t have to worry about the varying consequences and limitations of the two different types of worker stock options.

What Are The ISO Tax Benefits?

When Congress put in place Section 422 of the Internal Revenue Code, it was trying to make life easier for workers. The benefits that Congress was trying to put in place were:

  • No ordinary income tax on exercise; and
  • Capital gain on ultimate sale of the stock, if the two holding periods were met.

The problems:

  • The spread on the exercise is an Alternative Minimum Tax Adjustment, that has to be reported to the IRS. The AMT taxes due can be significant. They can in fact be so significant they effectively prohibit exercise because the employee can’t afford the taxes.
  • The employee has to meet two holding periods to qualify for the benefit. They have to hold the option shares for at least one year after exercise and at least two years after option grant. Most employees exercise in connection with a liquidity event and thus don’t meet the holding period requirements. If you don’t meet the holding period requirements the option is taxed as an NQO.

Summary of Differences

  • ISOs can only be granted to employees. You can’t grant ISOs to independent contractors or board members who are not employees. What this means is that–if you decide to grant ISOs to your employees, you are almost certainly going to have to also utilize NQOs. One reason I favor using NQOs for all types of awards is because it is simpler–you only have to figure out and explain the tax consequences of one type of award to your workers–not two.
  • ISOs have two holding periods.  Most employees won’t meet these requirements and thus not benefit from the ISO tax benefits.
  • ISOs have to be priced differently for 10% or greater shareholders.
  • For 10% or greater shareholders, ISOs can only have a 5 year term. NQOs are typically 10 year duration options.
  • ISOs give rise to Alternative Minimum Tax consequences. The AMT can be hard to figure out. This additional complexity makes life more difficult for everyone–the company and the employee.
  • You have to give the employee and the IRS notice of the amount of the spread on the ISO that is subject to AMT, by January 31st of the year following exercise. This creates somewhat of a trap for employees. With an NQO, you have to calculate the tax withholding on exercise. An employee can’t exercise until the company has calculated the withholding tax and made the employee write a check to the company for the employee withholding portion. This avoids a situation where the employee doesn’t understand the tax consequences until the subsequent year. There have been plenty of employees who realized too late they owed too much AMT–and that they couldn’t afford to pay it. This is a result that is usually avoided with NQOs.
  • There is a $100,000 annual limitation on the amount of ISOs that can become exercisable during any calendar year.
  • You can’t grant immediately exercsable ISOs without problems.
  • NQOs give rise to a tax deduction for the company. The spread on an ISO exercise is not deductible by the company. The spread on NQO exercises can add up to very substantial tax savings for companies.

ISOs Still Better for Employees

Having said all of this–ISOs are still more favorable to employees than NQOs. It is still possible for an employee to achieve a better tax result with an ISO than with an NQO. It might be unlikely, but it is possible.

Conclusion

If you really want to give your employees the best they can possibly get–use ISOs. If you want to keep your life simpler, and you understand that for the most part employees are typically not going to benefit from the potential tax benefits of ISOs, use NQOs.

Public Policy Recommendation

Congress ought to repeal the tax on transfers of illiquid stock to workers.

This would allow companies to transfer stock directly to workers without requiring the employee to write a big check to the employer to cover the employee’s share of income and employment tax withholding.

I am not sure of the public policy rationale for making it harder for companies to give workers equity. It doesn’t make sense to me.

 

 

Stock Bonuses Ought Not Be Taxable

You would think that stock bonuses to employees would be encouraged as good for societal and worker welfare.

However, this is sadly not the case.

The Tax Problem with Stock Bonuses to Employees

Here is the problem with employers paying stock bonuses to employees:

  • Stock bonuses are taxable just like cash compensation, despite the fact that the stock may be stock in a private company and not salable.
  • Both income and employment taxes apply to employee stock bonuses.
  • To receive a stock bonus, unless the employer is going to pay the employee’s taxes (an unusual event) employees actually have to write checks to their employers so that their employers can satisfy the employee’s share of and employment tax withholding.
  • The amount of income and employment taxes applicable to stock bonuses can be so significant that most employees would rather forego the award rather than pay the tax.
  • This adverse tax treatment of employee stock bonuses results in employers resorting to stock options rather than stock bonuses.
  • Stock options are less favorable than stock bonuses for a number of reasons, including, among other things: (i) stock options have to exercised in order for the stock to be issued to the employee; (ii) taxes may be due on exercise; (iii) the taxes due on exercise may be so significant as to dissuade the employee from exercising in full; and (iv) stock options ultimately expire.

Public Policy Recommendations

Here is what Congress should do:

  • Repeal the taxation of transfers of private company stock to company workers.
  • This will allow companies to more readily share equity with workers, which will increase worker and ultimately societal welfare.

100% Exclusion for Qualified Small Business Stock To Be Extended

Big news: On December 16, 2014, the Senate passed H.R. 5771, the Tax Increase Prevention Act of 2014. The bill now goes to the President. He is expected to sign it.

The bill would do a variety of things, but from a startup perspective one important thing it would do is renew the 100% exclusion from tax for gain on qualified small business stock received from qualifying C corporations during the calendar year 2014.

Qualified Small Business Stock

The 100% exclusion expired at the end of 2013. This bill renews the 100% exclusion for stock issued by qualifying C corporations issued before the end of 2014.

Thus, if:

  1. You received founder shares in a C corporation in 2014, or
  2. You invested in shares of a C corporation in 2014, and
  3. You hold those shares for 5 years,
  4. You may be able to exclude up to $10M in gain from the sale of those shares.
  5. There are a variety of other limitations that apply to the Section 1202 qualified small business stock benefit. For example, the corporation issuing the shares has to, among other things, be a “qualified small business,” have less than $50M in gross assets, have an active business, and be engaged in a qualified trade or business.

The Text of the Extension

1202

This 100% exclusion affects your choice of entity considerations significantly. Only C corporations can issue qualified small business stock. Thus, if you form an S corporation, your founder shares cannot qualify for the 100% exclusion.

The Cap on the Benefit

The 100% is not uncapped, but you can exclude up to $10M under Section 1202.

limitation

In Conclusion

This extension is good news for the startup world.

RSUs: Not a Great Fit For Startups

Startups frequently want to grant equity incentives to new hires and advisors. When they do, they want to know: What is the best equity incentive to use?

There Are a Variety of Possibilities

There are a number of different types of awards:

  • Stock awards (the issuance of stock, typically subject to vesting)
  • Stock options (the issuance of the right to buy a fixed number of shares, at the fair market value of the shares at the time of grant, exercisable after vesting and while providing service or some period of time thereafter; typically not exercisable until vested)
  • Restricted stock units (RSUs) (a contract right to receive a number of shares of stock upon vesting)
  • Phantom stock or shadow stock plans (a contract right to receive a cash payment based on the increase in the value of the company’s equity during a service period)

Frequently entrepreneurs are coming out of big companies that had RSU programs in place. They think RSUs might be a good choice for a startup.

But RSUs are not a great fit for startups for tax and liquidity reasons.

The Tax & Liquidity Problems

If you receive an RSU you are not taxed on grant. That is good. But you will be taxed on the value of shares delivered on vesting. And you will be taxed on the value of the shares at that time. This is problematic because (1) the timing of the timing of the tax is outside of the control of the award holder (i.e., time goes by), and (2) the shares are typically illiquid and cannot be sold to fund the taxes. Startups usually don’t have cash on hand to help company employees pay their taxes on their equity awards.

(Public companies are different because they have public trading of their shares and sometimes also have cash to help employees pay the taxes. Sometimes public companies will allow the players to pay their income and employment tax withholding by receiving fewer shares on vesting of the RSU. These options aren’t available for startups.)

At least with an option an optionee gets to choose when to exercise. This allows optionees to wait to exercise until they can afford to pay the taxes incident to exercising.

Sometimes companies will defer the vesting of an RSU until after an IPO or until the company is acquired. This is one approach to solve the tax and liquidity problems–but what if someone would have otherwise vested on a 4 year vesting schedule, wants to leave, and the company has still not gone public or been acquired?

Restricted Stock a Better Choice

If you are granting equity awards and your recipient can afford to pay tax on the value of the shares today, then grant restricted stock awards. This is a better choice than an RSU. With an RSU you are signing up to pay tax at a predetermined time (on vesting) but at a value to be determined at that future time. This is a bad idea. You might be signing up to put yourself in a tax find you can afford to get put of.

Think Option or Restricted Stock, Not RSUs

If you are a startup, RSUs are not a great choice. Think either restricted stock awards or stock options.

(By the way, Fred Wilson has written a really good post on these issues as well, which you can find here. As Fred points out, there are more tax complexities and nuances to the RSU tax picture than I’ve described here. Also, if your company is not a startup, but a company ramping to an IPO, an RSU plan might be a good idea. But if you are a startup or early stage, RSUs are more brain damage than they are worth.)