Equity compensation in the form of stock options is a common means of compensating key contributors to a growing business, especially where the cash compensation that these individuals receive is below the market rate for the skills and experience that they bring to the table. These stock options come in two different flavors: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs).

ISOs may only be granted to employees of a company (not non-employee directors, consultants, or advisors) and are eligible for favorable tax treatment relative to NQSOs if certain conditions are satisfied. As a preliminary matter, (i) the exercise price (i.e. the price per share at which the option may be exercised in order to purchase the underlying security) of an ISO must be at least equal to the fair market value of the underlying security on the date of grant (and must be equal to 110% of the fair market value of the underlying security on the date of grant in the case of 10% stockholders), (ii) ISOs cannot be transferred except on death, (iii) ISOs must be granted pursuant to a plan approved by a company’s board of directors and stockholders and within 10 years follow the date of adoption of such a plan, and (iv) ISOs must be exercised within the earlier of (A) 10 years of grant (5 years in the case of a 10% stockholder) and (B) three months of termination of employment (subject to extensions in the case of termination due to disability or death). Further, the aggregate fair market value of the securities underlying any ISO that are first exercisable during any calendar year may not exceed $100,000, determined at the time that the ISO is granted. If these conditions are met, the employee does not have taxable income at the time that the ISO is granted or exercised, except that the difference between the value of underlying security at the time of exercise of the ISO and the exercise price for the ISO is an item of adjustment for the purposes of the alternative minimum tax. In addition, if the underlying securities acquired upon exercise of an ISO are held until the later of one year following exercise or two years following the date of grant of the ISO, any gain or loss resulting from the sale or other disposition of the underlying securities would be treated as long-term capital gain or loss to the employee. If these holding periods are not satisfied, the disposition constitutes a “disqualifying disposition” that generally results in the ISO being taxes as an NQSO (described below).

NQSOs may be granted to anyone. NQSOs need not have any prescribed exercise price, transfer restrictions, or exercise terms; provided that any NQSO with an exercise price less than the fair market value of the underlying security on the date of grant will be subject to the application of Section 409A of the Internal Revenue Code, which can often result in very adverse tax consequences to the NQSO holder and, indirectly, to the company. The grant of an NQSO is not taxable but, unlike with respect to ISOs, the holder of a NQSO would have taxable ordinary income at the time of exercise of the NQSO equal to the difference between the value of the underlying security at the time of exercise NQSO and the exercise price of the NQSO. If the holder of an NQSO is an employee of the company, this amount is subject to withholding and employment taxes. When the underlying securities are sold, any resulting gain or loss would be treated as (i) short-term capital gain or loss (at rates the same as those for ordinary income) if the underlying securities were held for one year or less following exercise and (ii) long-term capital gain or loss if the underlying securities were held for more than one year following exercise.

As a practical matter, most ISO recipients never (or only partially) realize the tax benefits associated with ISOs since they typically do not hold the underlying securities for the one year minimum period following exercise.

In the context of a private company, options are generally exercised immediately prior to a sale of the company such that the employee exercises the ISO and then promptly sells the underlying securities along with all other stockholders of the company. Alternatively, ISOs may be cancelled in connection with a sale of the company in exchange for a payment equal to the spread between the sale price and the exercise price. In either case, employees often make the choice not to risk their capital by paying the exercise price for underlying securities prior to a liquidity event, especially in light of the applicability of the alternative minimum tax without a corresponding cash distribution to satisfy the tax obligation. In the context of a public company, the underlying securities are often sold immediately following exercise of the ISO in order to cover (in whole or in part) the exercise price for the ISO (i.e. a cashless exercise). In all situations described above, the employee has short-term capital gain or loss (at rates the same as those for ordinary income) on the difference between the price at which is the underlying security is ultimately sold and the exercise price for the ISO.

In sum, while much attention is paid to the beneficial tax treatment accorded to ISOs, these benefits are rarely realized by the employee recipients. Further, since the company may deduct the compensation expense associated with NQSOs (but not ISOs, unless taxed like NQSOs), the emphasis on granting ISOs to employees may ultimately be misplaced.