The Venture Alley
This is the worst scenario because a large gain on an ISO exercise could, in this situation, have the potential to trigger AMT liability for the preceding year's taxes and then when you have to sell the stock in the following year to pay for the AMT taxes it will be a disqualifying disposition so you then lose the tax benefit of the original ISO exercise and you'll have to pay taxes on the gain at sale as if it were ordinary income instead of short term capital gain. NQOs on the other hand have a taxable event to the employee when they are exercised, which can be very onerous. ISOs, short for incentive stock options, are a type of employee stock option only offered to key employees and top-tier management that can confer preferential tax treatment.
For more information regarding ISO and NQSOs, request our free reports.
Unlike NQOs, they are subject to many restrictions. They must be held for a much longer time period, and thus can carry more risk; however, they have a higher potential for better returns. As such, they can be offered to anyone. That means that you can extend them to not just standard employees, but also directors, contractors, vendors, and even other third parties.
ISOs, on the other hand, can only be issued to standard employees. Generally, this is limited to upper management and key employees. NSOs are generally taxed as a part of regular compensation under the ordinary federal income tax rate. Qualifying dispositions of ISOs are taxed as capital gains at a generally lower rate. A qualifying disposition for these purposes is defined as ISOs disposed at least two years after the grant date and one year after the exercise date, as long as the employee was continuously employed by the employer granting the ISO up to a time no more than three months prior to exercising the options.
There are very few limitations on how NQOs can be exercised. ISOs are subject to the above holding period in order to be exercised as such. Finally, options available to greater than 10 percent of all shareholders must be priced at least at percent of the fair market value on the grant date. Issuing ISOs is more complicated for companies, and more complicated to exercise for employees. That said, neither option should be considered too complex to issue if its benefits outweigh the costs.
Depending on your needs, the cost of creating a stock option plan can vary significantly. After deciding to grant ISOs to two of the company's key employees, the client asked whether they could issue additional ISOs to certain advisory board members.
While the client was clearly disappointed, the reality is that I should have taken a more practical approach and told them that even though the advisory board members were not eligible to receive ISOs and the associated favorable tax treatment, it may not matter. In the world of start-up and emerging companies, options are often only exercised immediately prior to a sale of the company. Employees, board members and other strategic partners affiliated with these companies often don't have the funds required to exercise the option or simply don't want to risk these funds unless the recipient can sell the underlying securities to a buyer for a profit shortly thereafter.
Under either of these scenarios, the recipient of an ISO that waits to exercise until immediately prior to a sale will not meet the associated holding period requirements and therefore would not be able to avail himself or herself of the tax benefits. Instead, the recipient would have short-term capital gain or loss taxable at ordinary income tax rates on the difference between the selling price for the securities and the exercise price for the ISO.
The results are twofold: The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. Does It Really Matter? Originally published October 9, The content of this article is intended to provide a general guide to the subject matter. Do you have a Question or Comment? Interested in the next Webinar on this Topic?
Click here to register your Interest. Events from this Firm. More from this Firm. More from this Author.