What is a ISO grant?

In short, an ISO is like a non-qualified stock option (NSO) (see last week’s Founder FOMO) but with more perks when it comes to tax treatment for the holder. Those perks, however, come with more stringent requirements.

When dealing with taxing options, there are 3 phases of an option when taxes may arise – at the time of grant, exercise, and sale of the underlying stock.

1. At grant, an ISO (like an NSO) is not taxed.

2. At exercise, an ISO is also not taxed on the spread (ie. the difference between the fair market value of the shares received and the exercise price of those shares) as ordinary income, although the spread is counted into the holder's alternative minimum tax (AMT); AMT is a big subject, so just make sure you speak with your tax advisor before deciding to exercise ISOs! In contrast, an NSO must recognize ordinary income tax on the spread at exercise.

3. At sale, an ISO is taxed at the more favorable capital gains rates shares underlying the ISO are held for (i) at least 1 year from the date of exercise and (ii) at least 2 years after the date of grant. An NSO, in contrast, is taxed at ordinary income rates.

As a result, ISOs are considered more tax-friendly than NSOs for holders because (i) there’s no ordinary income at the time of exercise and (ii) the holder may benefit from capital gains tax rates!

The IRS, however, doesn’t make ISO qualification easy and there are many requirements. Below bulleted are some of them.

- the issuer and the option agreement must state that the option is an ISO

- the holder must be an employee

- the holder cannot receive more than $100K worth of ISOs per calendar year

- if the holder owns more than 10% of the company's equity, then the exercise price of the options must be increased to at least 110% of the fair market value of the underlying shares

- after the holder stops serving as an employee, the holder must exercise the ISO within 3 months

- if a holder doesn’t leave, then the ISO will automatically expire after 10 years

With all these extra requirements, it's critical you make sure you are in compliance with ISO rules to avoid accidentally costing your option recipients!