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I remember at one point a startup will switch from offering ISO (Incentive Stock Options) to offering Non-qualified Stock Options (NSO) to employees?

Can the startup decide which to offer, and what are the basic tax consequences to employees when they leave the company and/or exercise the stock options? thanks.

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Types of Options

There are only two types of options that you will get at a startup — an Incentive Stock Options (ISO) or a Nonqualified Stock Options (NSO). In IRS speak, an ISO is called a Statutory option while an NSO is called a Nonstatutory option.

Incentive Stock Options

These type of options can only be issued to employees. They have certain tax advantages, the biggest being that ISOs are taxed on the sale of the stock not the exercise of the option. This means that you can exercise your options and not have to worry about taxes until you actually sell the stock. Well, not exactly. You do need to look into Alternative Minimum Tax (AMT) triggers since that plays by a different set of rules (see below). Some of the other rules that ISO’s follow are:

  • Must be granted at Fair Market Value (FMV)

  • Non-transferable

  • Must be granted 10-years after board approval

  • Must be exercised 10-years after the grant date.

Nonqualified Stock Options

All other options, at a startup, are typically NSOs. There are something called warrant’s, but those are usually reserved for outside investors, so we won’t deal with that here. NSOs are more flexible than ISOs but they don’t have the same tax advantages. The main thing about NSOs is that they are taxed when you exercise the option. This means they are taxed at ordinary income tax levels and you don’t get the benefit of long term capital gains. NSOs have the flexibility in terms of:

  • Can be given to anyone

  • Can be priced at, above or below the current market price, so no issues with FMV

It is critical that you understand which type of options you have. The tax implications are real and severe if you do the wrong thing. It’s best to consult a professional tax advisor as to your best course of action.

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Good answer... when you say "tax implications are real and severe if you do the wrong thing", do you have links to any references or example scenario? – NickC Sep 27 '10 at 18:49
Usually, the issues revolve around AMT and Long term capital gains. If you buy your options as they vest, then you can start the long term capital gains clock but this is tricky because if the are NSO's, you get taxed when you exercised them. If the stock falls in value, you still own taxes on the exercise price. AMT is another gotcha since it's totally different than our normal tax code and ISO's can trigger it. It's best to speak with a tax professional about your specific situation to get a better idea. – Jarie Bolander Sep 29 '10 at 12:41
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Qualified versus non-qualified stock options are distinctions based on tax treatment.

Non-qulaified stock options are taxed immediately on any "income" (difference between exercise price and market value) at ordinary income tax rates. This tax is assessed regardless of when and if they are later sold.

Incentive stock options - typically offered to executives - are only taxed on any gains (lower tax rate than income tax rate) if and when they are sold. This can be a long-term capital gain rate if certain holding periods are met, among other conditions. The Alternative Minimum Tax rules do apply to ISOs, as Jarie points out.

Employees will typically lose all rights in and to options that are not exercised (within three months usually). Unvested options are cancelled and returned to the treasury.

You can use either plan but incentive stock options, by their nature are restricted to employees.

Employers prefer non-qualified options because the company takes a tax deduction on the amount reportable by the recipient.

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