David Kahn

Q: What’s the difference between A nonqualified stock option (NQSO) and an incentive stock option (ISO)?

A: There are two types of stock options: NQSOs and ISOs. Both give employees the opportunity to buy their company’s stock at a specified price.

NQSOs are taxed at ordinary income tax rates at the time they are exercised and are not subject to the Alternative Minimum Tax, which is 28%. They can be gifted during the life of the option holder, if the plan permits. The disadvantages of NQSOs are that the difference between the exercise price and the market price is taxed as ordinary income, and that the employee must come up with the cash to exercise the option.

If they meet certain requirements, ISOs may be taxed at a long-term capital gains tax rate, which is lower than the income tax rate. But ISOs may incur the Alternative Minimum Tax at the time they are exercised. One disadvantage of ISOs is that the corporation does not get a deduction when employees exercise the option, but only when the employee sells it. In addition, ISOs cannot be gifted.

Bottom line? “An ISO is better because it’s taxed at a long-term capital gains tax rate, which is potentially a cheaper rate than the NQSO, which is taxed as ordinary income. In other words, it’s cheaper to have an ISO,” said David Kahn, a CPA and personal financial specialist with American Express Tax & Business Services in Manhattan.