There are two main categories of stock options that can be granted by a company: 

Incentive Stock Options (ISOs) 

Non-Qualified Stock Options (NSOs)

There are several important differences between the two:

• ISOs can only be issued to employees 
• NSOs can be issued to consultants and directors
• ISO exercises are limited to $100,000 in total fair market value in any calendar year (determined at option grant)
• Tax implications of option exercise and stock sale 

Tax Treatment 

When an employee exercises an ISO, there are no capital gains taxes recognized (however there are AMT implications). With ISO’s, you incur tax consequences when you sell your shares.

When an employee exercises an NSO, ordinary income is recognized on the bargain element (aka compensation element). This can be calculated according to the following formula: 

=(market value per share on date of exercise – exercise price) x (quantity of shares)

For NSO exercises, the employer will withhold taxes on your behalf to cover the tax liability incurred from the bargain element. 

ISO Qualifying Disposition 

There is one potentially major tax advantage for ISOs. 

If both of the criteria below are met, any gain recognized upon selling the shares would be taxed at long-term capital gains rates: 

• shares are held for more than one year after date of exercise of the ISO 
• shares are held for more than two years after the grant date of the ISO

For certain individuals, the difference between short-term and long-term capital gains rates can be substantial. Meeting the standards for a Qualifying Disposition could result in significant tax savings. 

However, there is one major disadvantage to this strategy. It requires you to hold on to your employer’s stock for an extended period of time. This is a relatively risky situation. For example: if your company experiences financial difficulties, you could be facing job loss and declining stock values simultaneously (see this blog post to learn about the pros & cons of holding employer stock for extended periods.) 

You can hold on to your exercised ISO shares with the hope of paying less taxes. However, if the stock price falls during the holding period, the price decline could wipe out any potential tax savings you were hoping to realize. In other words, if the stock price dropped, you would have been better off paying the taxes (at higher ordinary tax rates) and selling your shares sooner for a higher price.

The tax impact of your stock option package is a critical piece of your overall tax planning strategy. Always consult with a CPA or qualified financial professional to understand the tax implications of your NSOs and ISOs.