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Equity Compensation is a vehicle for paying employees, directors and other consultants for work they perform for an organization. The most popular form of Equity Compensation is the Employee Stock Option (ESO).

ESOs come in two major forms that companies need to be aware of prior to making grants to their employees through an equity compensation plan. The types of employee stock options are Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQs).

This blog entry is a preliminary discussion about the difference between ISOs and NQs.

What are the Key Differences Between ISOs and NQs?

Incentive Stock Options are qualified compensation per the Internal Revenue Code Section(IRC) 422. There are many administrative and tax rules that apply to this type of option.

Non-qualified Stock Options are as the name implies, non-qualified compensation per IRC Section 422. Accordingly they are less restrictive as to whom they can be granted to and how the administration and taxation takes place.

What are the Administrative and Taxation rules for ISOs?

Incentive Stock Options have administrative rules that can make them complex to handle for an accounting and payroll departments.

• If ISOs are granted to an individual holding more than 10% of the company’s equity, then the grant price must be at least 110% of the fair market value of the company stock on the grant date.
• ISOs must be granted only to employees and directors of a company. Contractors are ineligible to receive incentive stock options.
• The Contractual Term of ISOs must be limited to 10 years from date of grant.
• ISOs must be exercised with 3 months of termination to qualify for special tax treatment.
• An ISO grant must be approved by the Board of Directors and the Shareholders prior to being granted by the company.

Disposition After Exercise

There are two types of dispositions for Incentive Stock Options once exercised:

• Qualifying dispositions occur when the underlying stock is held for at least 2 years from grant date and 1 year from the exercise date.
  • If these rules are not met, then the ISOs are said to have a non-qualified, or disqualifying disposition.
• When ISOs have a qualifying disposition, the total amount of gain resulting from the spread between the exercise price and stock selling price is treated as a long-term capital gain (beneficial tax treatment)

• The consequence of disqualifying disposition is that the options lose their special tax status and become treated as non-qualified stock options.
• The tax treatment of NQ exercise dictates that the spread between the exercise price and stock price on the day of exercise is treated as ordinary income (W2 or 1099 income), and that when the stock is sold, the difference between the price on day of exercise and final selling price is treated as a short or long-term capital gain depending on how long the stock is held from the day of exercise.

ISQ/NQ Tax Treatment Example

Marginal Tax Rate	39.6%
Long-term CG Tax Rate	20.0%
Long-term CG Tax Rate	20.0%
Total Options	1,000
Grant Date	1/1/2010
Stock Price on Grant	$10.00
Exercise Date	1/2/2012
Stock Price on Exercise	$30.00
Sell Stock	1/3/2013
Stock Price on Selling Date	$60.00
ISO Taxes	$60.00 - $10.00 = $50.00 ; long-term capital gain taxed in 2013  $50.00 X (1 – 20.0%) = $40.00 After Tax Income / Option  $40.00 X 1,000 = $40,000 Total After Tax Income *AMT Tax Rules would apply
NQ Taxes	$30.00 - $10.00 = $20.00 ; ordinary income taxed in 2012  $20.00 X (1 - 39.6%) = $12.08 After Tax Income / Option $60.00 - $30.00 = $30.00 ; long-term capital in taxed in 2013  $30.00 X (1 – 20.0%) = $24.00 After Tax Income / Option  $12.08 + $24.00 = $36.08 After Tax Income  $36.08 X 1,000 = $36,080 Total After Tax Income

Is There a Difference in the Fair Value Because of the Tax Treatment of ISO vs NQ?

Determining the fair value of an ISO or an NQ option is exactly the same for both equity compensation instruments. Even though there is an income value difference for the recipients of employee stock options because of the different tax treatment, there is no accounting difference in the fair value. FASB ASC 718 states that the fair value of options must be determined using at least six variables. They are as follows:

• Underlying Stock Price
• Exercise Price of the Option
• Expected Term of the Option
• Expected Volatility of the Option
• Risk-free Interest Rate
• Expected Dividends of the Company during the life of the Option

Many companies use a closed-form model such as Black-Scholes-Merton to determine the fair value of their employee stock options.  We present a list of the valuation methods used by each of the  Dow 30 companies. Although many companies use Black-Scholes-Merton to value their ESOs, it is only one of the several models that may be used to value employee stock options.

Please check back on www.fintools.com for more information on how we may assist you, not only in the valuation of equity compensation, but also in the administration and financial reporting that is required for these instruments of compensation.

If you have any comments, please feel free to contact us at 610-688-8111 or email miti@fintools.com