What Are Your “Options”?
Stock option plans can help set the foundation of an effective compensation and retention strategy for your company. These incentive structures help align your interests with those of the key people who work for you. They do so by requiring an investment for the right to become a shareholder in your company and participate in its potential success and future upside. Stock option plans are also great tools to retain talented people without using cash, which can be valuable during the formative years of your company when you need to reinvest cash flow into your business.
Incentive Stock Options (ISOs)
- Employees do not need to recognize receipt of income for income tax purposes at the time of the ISO grant, nor at any time thereafter, until they sell the shares after exercising their options.
- Income from an ISO – defined as the option value at sale minus the option value at issuance – may be taxed as a capital gain rather than income for income tax purposes, assuming the issued stock is held at least a year after exercising the ISO.
- There are no employment/payroll taxes (e.g., Medicare and Social Security) with ISOs.
- Your employees can only exercise the option while still an employee or within three months of termination (or within 12 months if due to death or disability)
- ISOs are not subject to section 409A of the IRS tax code, which governs deferred compensation. This allows employees to avoid additional taxes, including potential accelerated income inclusion at the ISO vesting date as well as an additional income tax of 20%
- ISOs have certain restrictions – including a minimum two-year vesting period and a one-year holding period prior to sale. This can provide you with more leverage to retain employees if they wish to participate in the potential upside of the options.
- Your company cannot take tax deductions for an ISO, either at the time of grant or exercise of the option.
- ISO plans are generally more difficult to administer.
- You can only grant ISOs to full-time employees only (i.e., not consultants)
- The term of the ISO cannot exceed 10 years from the date of grant
- The employee may be subject to Alternative Minimum Tax (AMT) at the time of exercise of the ISO.
- ISOs have more restrictions – including a minimum two-year vesting period and a one-year holding period prior to sale. Employees may not be patient or risk-tolerant enough to wait for the potential payout.
Non-Qualified Stock Options (NQSOs)
- Your company can take tax deductions for NQSOs when exercised (on the spread between the market value and the exercise price).
- NQSO plans are generally easier to administer.
- You can grant NQSOs to anyone who works for you (including non-employee consultants, for example).
- Employees do not need to recognize income for income tax purposes on the NQSO grant date.
- NQSOs are generally less restrictive than ISOs in terms of vesting, which could help incentivize your employees over a shorter term.
- Both your company and your employees must pay employment/payroll taxes on any NQSO plan payments (though for you as the owner, the NQSO plan tax deduction typically outweighs this factor)
- Employees of your company must recognize the receipt of income upon exercise of the NQSO.
- NQSOs are less restrictive than ISOs in terms of vesting, which also may provide you less leverage over retaining your employees over the longer term.
Which Option is Best for You?
Every company situation is different. However, one of the more common lines in the sand drawn between ISOs and NQSOs is the different tax implications of both plans. ISOs can be a great option for start-up companies still years away from generating taxable income, whereas NQSOs offer income tax deductions. Modera Wealth Management LLC can help you decide which stock option plan may be the best alternative for your company.
Information sourced by Modera Wealth Management’s financial advisors in Atlanta, GA.
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