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Incentive Stock Options (ISOs) vs. Nonqualified Stock Options (NQSOs) – Knowing the Difference is Key – Did You Know Series

Did you know?
What is better ISOs or NQSOs?

This week, one of the boards I sit on that is preparing to go public, asked the question – “What is better – ISOs or NQSOs?” It’s such a great question and actually, one of the easier questions I have gotten as a board member, so let me share.

ISOs often qualify for more favorable tax treatment while NQSOs do not. Tax treatment for ISOs was originally created by the Revenue Act of 1950. In the following decades, stock option grants became very popular as a form of compensation – BUT primarily and exclusively for top executives! In addition, capital markets at that time did not have the volatility they have today, so this compensation vehicle was very time and person-specific when it was created – KEY TO KNOW.

The introduction of other long-term incentive vehicles began in the late 60s, but with Accounting Principle Bulletin (APB) 25 in place, where options granted at fair market value (FMV) had no change (and other vehicles did) to earnings, options dominated the compensation landscape. And in a bull market like we had starting in 1983, options and ISOs are tremendous compensation tools!

Why ISOs Lost their appeal

But in 2006, FASB passed FAS 123R, requiring companies to calculate a “fair value” of an option and make it a direct expense to a company’s P&L. Once this happened, options (which can be much more dilutive than other compensation vehicles due to being “appreciation only”) started to lose their luster in the marketplace. In addition, it was posited in the Enron trial that options – and the way they are structured – caused some of the poor oversight by their board! As a result of Enron, in October 2004, section 409(a) of the code was added by the American Jobs Creation Act, which set rules requiring the strike price of an option grant to be AT LEAST the fair market value, giving rise to the term 409(a) value.

As a result of FAS 123R and 409(a), stock options – including ISOs – are no longer very common forms of long-term equity awards for executives.

Finally, as you will read in this great article, ISOs have to deal with what is known as the Alternative Minimum Tax. This means there better be some great financial education given to all recipients before granting, since a recipient can actually owe taxes upon the sale of an ISO – they would have no final value! The boom had more of its share of people that went bankrupt due to this GIANT nuance.

In sum, ISOs were “the bomb” in the 60s, 70s and 80s – but today with alternative minimum tax AND market volatility… they could end up being the bomb that destroys your company.

Caveat emptor!

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