United States: Incentive vs. Non-Qualified Stock Options: Does It Really Matter?

Last Updated: December 13 2014
Article by Kevin M. Granahan

I recently assisted an emerging company client of mine with a fairly common project in the world of corporate law: the adoption of its first stock option plan. The benefits of issuing stock options and other forms of equity-based incentive compensation are well documented for start-up and emerging companies, and the circumstances for my client were no exception. The company wanted to supplement its limited ability to compensate its employees with cash by issuing stock options that would vest over time. This approach often aligns the interests of the company with its employees by incentivizing the employees to remain employed with the company over time while at the same time giving them a tangible stake in increasing its value.

Immediately after the plan was put in place, I had a general discussion with the company's management about the two types of stock options available for issuance under the plan: "incentive stock options" (ISOs) and "non-qualified stock options" (NQSOs). ISOs offer recipients certain tax benefits if specific conditions are met, while NQSOs do not. See Startup Law Talk's post entitled "What is the difference between incentive stock options and non-qualified stock options?" for a good overview of these conditions and the resulting tax benefits. If the conditions applicable to ISOs are met, the recipient will not have taxable income at the time the ISO is granted or exercised (except for certain alternative minimum tax requirements that may apply) and will only be taxed at the time the recipient sells the underlying securities he or she receives upon exercise of the ISO. Further, if the recipient holds the securities he or she receives upon exercise for at least (a) one year following the date of exercise of the ISO and (b) two years following the date of grant of the ISO, any gain or loss resulting from a sale of the underlying securities will be treated as long-term capital gain or loss to the recipient. If these holding periods are not satisfied, the sale of the underlying securities would be a "disqualifying disposition" under the Internal Revenue Code, the ISO would be taxed as a NQSO, and the favorable long-term capital gain or loss tax treatment would disappear.

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. I told the client "no" since Section 422 of the Internal Revenue Code provides that only employees are eligible to receive ISOs. 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.

Why not? 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: (1) many employees of start-up or emerging companies do not end up reaping the tax benefits of ISOs; and (2) I am hopeful that my client and its advisory board members feel better now that they know this.

Originally published October 9, 2014

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