ISOs and Nonqualified Stock Options

Distinguishing between incentive stock options and nonqualified stock options.

This page is for people who received options from their employer but are not certain what type they received. The two types are incentive stock options ("ISOs") and nonqualified stock options ("NQOs"). The tax rules for the two types of options are very different, so it may be important to know which kind you have.

Note: Options you buy from a broker, or receive as a distribution on stock you own, are not in either of these two categories. In this discussion, we are concerned only with options you received because you provided services to the company issuing the options.

Note: Sometimes employees exercise their options and sell the stock immediately. If this is your situation, it doesn't matter whether you have ISOs or NQOs, because the special tax treatment of ISOs only applies if you hold the stock for a specified period after exercising the option.

If You're Not an Employee

If you're not an employee, the answer is very simple: you have nonqualified options. This applies to outside directors, consultants and independent contractors. You can receive ISOs as a "contract employee," provided that you are treated as an employee of the company issuing the options or a subsidiary. The tax law says that ISOs can only be issued to employees (people who receive W-2 income).

Warning: The opposite is not true! Employees can receive ISOs or NQOs. If you are employed by the company that issued the options, or a subsidiary of that company, you need to inquire further to find out what type of options you have.

Just Ask

The most obvious way to learn what kind of options you have is to ask the company that issued them. There are just two problems with this approach. Sometimes the company doesn't know, either because they were sloppy in their record keeping or they don't understand the distinction clearly enough. And sometimes you talk to someone who thinks he knows the answer when he really doesn't. It is highly recommended that you ask the company which type of option you have. But it's also highly recommended that you check the answer, if you can.

The Option Agreement

When you receive an option for services, you should receive a written document known as an Option Agreement. This documents sets forth the major terms of the option: the number of shares you can buy, the purchase price, and the terms under which you can exercise the option. You should have a copy of the agreement; if you can't locate a copy, you should be able to obtain a copy from the company.

• If the option agreement says the option is not an ISO, then that is your answer. Even if the option meets all other requirements to be an ISO, the tax law says it is not an ISO if the option agreement declares that the option is not an ISO.
• If the option agreement says the option is an ISO, then that should be your answer. Just saying that an option is an ISO is not enough to make it an ISO (see below). But it's reasonable to expect that any company that intends to grant ISOs will make sure all requirements are met. If you have reason to believe the company is poorly managed or disorganized, you may want to do further checking to make sure you really have ISOs.

Other Indications

If you can't locate the option agreement, or the option agreement does not specify whether the options are ISOs, there may be other ways to determine what type of options you have.

• Options are usually issued under a document called a stock option plan. You may be able to obtain a copy of that document and determine by reading it whether your options are ISOs or NQOs.
• Options must meet a variety of requirements to be ISOs. If you can determine that your options fail to meet one or more of these requirements, you know you have NQOs. For example, ISOs must be issued pursuant to a plan that has been approved by the company's shareholders. ISOs can't be issued for a price that is lower than the fair market value of the company's stock at the time they're granted, and they can't extend for a period of more than 10 years.

If all else fails, you may have to rely on a tax professional to track down the answer to this question.

1  2  3  4  5  6  a  b  c  7