Incentive Stock Options Vs Non-Qualified Stock Options
Stock options are "compensation tools" that companies use to "recruit, retain and motivate employees," according to Entrepreneur Magazine. Employees granted stock options can purchase ownership in the company within a certain period, sometimes at a discounted price. In addition to offering this compensation incentive to top executives, companies offer stock options to hourly employees. Because stock options give employees some ownership of the company for which they work, employees feel more involved with their employer.
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Incentive Stock Options
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The IRS created the incentive stock options (ISOs) category to offer certain tax benefits over non-qualified stock options. All ISOs issue under an ISO agreement and certain eligibility requirements must be met to qualify for ISOs. For example, only employees can receive ISOs. Further, the ISO must issue at fair market value and the value cannot exceed $100,000. ISOs are nontransferable; the company must grant the ISO within 10 years of shareholder approval, and the employee must exercise his stock option within 10 years of the grant.
Non-Qualified Stock Options (NSOs)
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Often, stock options that do not meet the eligibility criteria of incentive options fall in the category of non-qualified stock options. Unlike incentive stock options, non-qualified options are not limited to employees; companies can issue NSOs to any service provider including partners, consultants and board members. The company can choose to grant NSOs at any exercise price, above or below the fair market price, and NSOs may or may not be transferable. Further, there is no limit on the value of stock in non-qualified stock options.
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ISOs versus NSOs
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Companies may choose to offer both ISOs and NSOs, depending on the situation. ISOs offer tax advantages, in that the gains may be subject to the lower capital gains rate than the higher ordinary income rates at which NSOs are treated. Incentive options are, therefore, more desirable for employees and are often reserved for upper management, while NSOs are reserved for lower management. NSOs, however, also have their advantages: they are much more flexible than ISOs, can be transferable to dependents and the company can offer discounts.
Tax Consequences
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Tax consequences for ISOs are generally considered more favorable than those for NSOs. With ISOs, employees face no taxes at the time of grant or exercise. Additionally, employees achieve a 15 percent or less capital gains tax upon sale, while the company usually faces no deductions. With NSOs, the recipient pays income tax between 10 to 35 percent on the price break he gets on exercise with no company deductions. It should be noted, however, that the tax benefits associated with ISOs are increasingly reducing due to the alternative minimum tax.
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References
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