If you want to begin analysing the essential differences between non-qualified stock options (NSO) and incentive stock options (ISO), you first need to understand what they are.

Stock options are a kind of equity compensation offered by companies to their employees. Instead of granting shares of stock, employees receive derivative options on the stock. The terms and conditions associated with stock options are specifically spelt out for employees in the options agreement itself. Mostly, an employee benefits from a stock option when the company’s stock attains a greater value than the exercise price of the stock. Primarily, there are two types of stock options. These are, ISO or statutory stock options and NSO, which are also referred to as non-statutory stock options.

Let’s explore NSO vs ISO and compare the chief differences between the two.

1. Tax Liability

An ISO often leads to less tax if the exercise (strike) price is almost equal to the fair market value (FMV) as of the grant date. However, for an NSO if the exercise price is at least FMV as of grant date.

2. Eligibility

When it comes to NSO vs ISO, one of the key dissimilarities between the two stock options is that NSO is only reserved for being issued to employees. On the other hand, an ISO can be issued to employees as well as independent contractors or service providers, which also includes non-employee directors.

3. Taxes due

In case of an ISO, tax is not due until the holder/employee sells the stock option. On the other hand, for an NSO, taxes must be paid as soon as the stock option is exercised. Which means at the time of the recipient/holder paying for the stock option. This is because an NSO is considered part of the income of the employee. Therefore, in contrast to ISO, an NSO involves taxation on the stock even before the employee can sell the stock.

4. Company’s benefit

From the perspective of the company, an NSO is far more beneficial as it allows the company to deduct taxes right from the moment when the employee exercises the stock option.  This is not possible in the case of an ISO, thereby making NSO the more practical choice for the company.

5. Post-employment exercise period

In terms of NSO vs ISO, one of the key differences is that an ISO must be exercised within three months after termination of employment. This period can only be extended in the event of death or disability. In contrast, an NSO can be exercised at any time before the expiration date of the stock. ISOs are only applicable while the holder is still employed at the company, while NSOs don’t require employment.

6. Restrictions 

Some of the important differences between NSO and ISO lie in the restrictions. While an NSO has to adhere to Section 409A strictly, the valuation of an ISO is less stringent. An ISO is also highly regulated under Section 422 of the Internal Revenue Code. For example, it is non-transferable under all circumstances, other than the death of the recipient of the stock. This is not the same for NSO.

Another example if that of the value of a stock that can be exercised every year. For ISO, only $100,000 worth of stock can be exercised annually. Beyond this cap, any stock exercised is treated as an NSO.

7. Rigidity associated

A certain operational rigidity is associated with an ISO. For instance, in most circumstances, such as one in which the employee doesn’t hold the ISO for the minimum holding period, it is treated as an NSO. If the stock is not held for two years from the date when the ISO was first granted and a year from the date on which the stock option was exercised, it is considered an NSO.

These are some of the chief differences between ISO and NSO that are considered by employers while selecting stock options for their employees.