Stocks Options and Nonqualified Stock Options vs Incentive Stock Options

By Drew Stevens - December 10, 2018 - Securities

Considered by some to be the classic employee equity incentive plan, stock options can be advantageous for both a company and an employee. A good business lawyer can help structure stock options to incentivize valuable employees to hit certain performance metrics and stick around with the company for a certain amount of time. Here, our business law attorney in Columbus, Ohio will dive into the two kinds of stock options – incentive stock options and non qualified stock options (also called non statutory stock options).

What is a Stock Option?

Although employee stock option programs can be designed to be fairly complex, the overall concept of the stock option is relatively straightforward. A stock option is an agreement between an employee and your business where the business grants the employee the ability to buy a specified amount of your company’s shares, at a certain, fixed price and for a certain amount of time. When an employee wants to pull the trigger on buying the stock, this is referred to as the employee “exercising” the option. The “strike price” or the “exercise price” is the price per share that is specified in the stock option agreement. Some stock options agreements will specify the time period in which the employee has the ability to exercise the option, before it expires.

Let’s look at a typical stock option example. Your startup grants Walt Worker a stock option that vests 33% per year, for three years, and the stock option has a total term of five years before it expires. The option is for 300 shares, at a strike price of $50 per share. Walt can exercise his option to buy 100 shares after the first year, when 33% of his total shares vest. In another scenario, after the first full three years, Walt can exercise his full option and pay the company $15,000 to acquire all 300 shares. If Walt does not exercise his full option and only buys 200 shares within the five years, upon the fifth year anniversary, Walt’s option expires, and he will be unable to purchase the remaining 100 shares.

The tax treatment for Walt will depend on whether the options are NSOs or ISOs.

Non qualified Stock Options

If Walt and his company’s stock option is an NSO, both Walt and the startup must be aware of the tax consequences. With an NSO, Walt will be taxed at his ordinary income rate on the difference between the strike price and the fair market value price, when Walt exercises his option to purchase shares. Meanwhile, your startup can deduct this corresponding amount. Once Walt goes to sell his shares, such sale will be taxed at Walt’s short-term or long-term capital gains rate, depending on how long Walt holds his shares.

Incentive Stock Options

If you’re Walt, you may greatly prefer that your stock option is an ISO and the eventual sale of the stock is a “qualifying disposition”. If a stock option is an ISO, then Walt can defer the taxation that would hit when Walt exercise his option (as with the NSO) until the later date of the actual sale of Walt’s shares. Further, Walt will only have to pay taxes at his capital gains rates, as opposed to being hit with taxes at the ordinary income rate. For this to happen, the following requirements must be met:

1. Walt must hold his stock for at least a year after his exercise date and for two years after the grant date.

2. No more than $100,000 of stock can be exercised in a calendar year.

3. The strike price of the stock cannot be less than the fair market value of the stock, as of the date of the original date of the stock option grant.

4. The ISOs are only granted to company’s employees.

5. The ISO was granted according to a written stock options plan that was approved by the company’s shareholders within 12 months after the board of directors approves the plan. Core components of the plan that must be in writing include how many total shares will be issued under the stock option plan and which types of employees will be eligible for the stock options.

6. The 10-year rule: the stock options must be granted to Walt and other employees within 10 years of the board of directors’ approval of the stock options plan. Further, Walt has to exercise his option within 10 years of the stock option grant date.

7. Finally, if through the stock option, Walt ends up owning more than 10% of the total voting power of all company outstanding stock (as of the original grant date), then the ISO strike price must be no less than 110% of the fair market value, and Walt’s option cannot be exercisable for more than 5 years.

If Walt and the company meets all of these requirements, then when Walt goes to sell his shares, they are classified as a qualifying disposition. Walt will only have to pay long-term capital gains taxes on the difference between the strike price and the sale price. Unfortunately for your company though, your company will not receive any corresponding tax deduction. 

Properly structuring stock options and documenting a stock option plan can involve a number of factors, and there is a lot of room for error. If you think you need the assistance of our Columbus securities attorney, please do not hesitate to contact us.