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.

 

 

New Contact Information, and a Song for Your Amusement

If you haven’t heard, I am moving my law practice to a new firm: Carney Badley. I am lucky to have my good friend and former colleague and IP transactions lawyer Mike Schneider joining me. GeekWire wrote a really nice piece about us.

My New Contact Information

My new contact information is as follows:

Joe Wallin
Principal
wallin@carneylaw.com
Office: (206) 607-4157
Cell: (206) 669-0997

I’ve been telling folks about my move, and one of my clients sent me the following song to express how he felt about it. I thought it was funny.

A Song For Your Amusement

Here are the lyrics, and here is the song:

There isn’t an ocean too deep

A mountain so high it can keep me away

I must follow him, ever since he touched my hand I knew

That near him I always must be

And nothing can keep him from me

He is my destiny

I love him, I love him, I love him

And where he goes I’ll follow, I’ll follow, I’ll follow

He’ll always be my true love, my true love, my true love

From now until forever, forever, forever

I will follow him, follow him wherever he may go

There isn’t an ocean too deep

A mountain so high it can keep, keep me away

Away from my love

Accredited Investor Definition: Operating In the Dark

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I have been reading the Recommendation of the Investor as Purchaser Subcommittee and the Investor Education Subcommittee: Accredited Investor Definition carefully. There is a lot to digest in this report.

I am particularly struck by the below paragraph.

One thing that is evident is the degree to which the Commission is currently acting based on incomplete information when it comes to developing policy with regard to Rule 506 offerings, including with regard to the accredited investor definition. As the Commission noted in the release for the final rule lifting the ban on general solicitation in Rule 506 offerings, it has
“relatively little information on the types and number of investors in Rule 506 offerings.” This makes it difficult if not impossible for the Commission to reliably measure the likely impact of any changes to the accredited investor definition. This should not be seen as an excuse for inaction, however. Rather, the Commission should take immediate steps to collect the data that would allow it to better assess its policy options going forward.

The Committee goes on to make 5 specific recommendations. I listed them in my last blog post.

The Discussion At the Last Committee Hearing

At the last Investor Advisory Committee hearing, there was a good discussion of this point about not having enough information to make an informed decision. I transcribed a part of the last hearing on this point. Here is how it went:

Joseph V. Carcello had this to say:

Could I just make a broader general point that I think is important for the staff.  You know, this is an area where there’s a surprising lack of even basic descriptive statistics.  What, for example, is the, you know, distribution of the size of investments that are made by individuals into Reg. D private placements?  What percentage of these investments come in from accredited investors?  What percentage come in from unaccredited investors under 506 who are relying on purchaser representatives?  What do we know in general about the risk and return profile of private placement investments?  What percentage of them even return the initial investments?  What’s the variance?  How does that compare to the risk and return that you would get in a, you know, index fund or what have you?  These are basic descriptive statistics about the market as a whole that to the best of my knowledge really are lacking.  And it seems that if we want to do the best possible job for all participants in the process, for the companies that are offering securities pursuant to Reg. D, for the investors that are buying, and for the intermediaries in the market, it would behoove all of us to get some of this basic data.  And the only way we’re going to be able to get it is unfortunately if the Commission rolls up its sleeves and does, you know, survey work in this area.

To this, Barbara Roper responded as follows:

Thanks, Joe.  And I would just add there is—one of the points that we discuss in our draft recommendation is this notion that the Commission is operating to a large extent in the dark in developing policy in this area.  There is, for example, an acknowledged problem that many Reg. D offerings do not file Form D.  We don’t know how many.  There’s, because of the way the regulations are written, even for those that do file the form, there isn’t a closing form.  So there’s a lot you don’t know about what they actually raised, and what then happened with the offering.  And so we anticipate that included in our recommendation would be a restatement of our previous recommendation that the Commission approve the changes to the Form D filing requirement that would allow it to collect additional information to assess some of these issues.  That staff has done work, you know, if you read the economic analysis in the General Solicitation Final Rule—you know, they’ve reported what they know, based on the information that they get from the—you know, from the forms that are filed.  And it’s useful.  But it is, by definition, an incomplete data set, and we don’t even know how incomplete.  And also arguably not representative, since those issues that actually take the step of file are presumably sort of different from those that don’t.  So, I think, absolutely, I agree, Joe, that there is a useful place for more data in this and that, as you know, that will be reflected in the recommendation that comes from our subcommittee.

Then James Glassman, Executive Director of the George W. Bush Institute, at about the 1:04 mark, said this:

In your comments you alluded to the fact that there could be an economic effect if there was a straight inflationary increase in the limits. I like to just second what Joe said about the importance of research. It would be good to do some economic research on what would be the effects if we made any changes at all on the economy; I think there would be some economic effects. I just want to say I think that the SEC tries to be diligent in these efforts but in general frequently in the dark about economic effects. I think it is important for the SEC to look at those kind of things. Here is an perfect example where we can do research, not just in the areas that Joe talks about, but in broader economic terms. I think that should be a strong part of the recommendations; we shouldn’t make changes unless we know what the effects are going to be or get a pretty good estimate of what they are going to be.

I do not think the committee or anyone else should be revising or recommending revising the definition of “accredited investor” until the economic impacts are understood.

How Many Future Jobs Will Be Vaporized?

So, for example, if we simply adjust the financial thresholds for inflation, and 2/3rds of currently qualifying angel investors no longer qualify–how many jobs that would otherwise have been created will not be? Shouldn’t we get a reliable economic estimate before we proceed?