By Kaye A. Thomas
Current as of January 7, 2015
How to determine whether your options are ISOs or nonqualified options.
Options that are issued by companies to employees and others who provide services to the company come in two flavors: incentive stock options (“ISOs”) and nonqualified stock options (sometimes called “nonquals” or “NQOs”). The tax rules for the two types of options are very different, so it’s important to know which kind you have. Here are some guidelines.
Note: Options you buy from a broker, or receive as a distribution on stock you own, are not in either of these two categories. In this discussion, we are concerned only with options you received because you provided services to the company issuing the options.
If you’re not an employee
If you’re not an employee, the answer is simple: any options you receive are nonqualified. This applies to outside directors, consultants and independent contractors. You can receive ISOs as a “contract employee,” provided that you are treated as an employee of the company issuing the options or a subsidiary. The tax law says that ISOs can only be issued to employees (people who receive W-2 income).
If you are an employee
Employees — this means everyone who receives a W-2, from the CEO on down — can receive either ISOs or nonquals. Sometimes they receive both, even in a single grant, perhaps because of a limit on ISO grants in the tax law or possibly due to a policy adopted by the company.
Option agreement. When the company granted the option, you should have received a stock option agreement setting forth the terms of the option. Often this is a two-part document, with the first part being called something like “notice of stock option grant.” These documents should clearly state whether you received ISOs or nonqualified options. A statement that the option is not an ISO will definitely establish it as a nonqual. A statement that it is an ISO is usually reliable but could be incorrect due to some kind of error or an event that changed the status of the option after it was granted.
Company records. It’s a good idea to check company records, particularly if the option agreement indicates you have an ISO. Discrepancies sometimes occur, and you don’t want to find out the company believes you have a nonqual after building your strategy around the assumption that it’s an ISO. If your company offers online access to your option records, take a look. If they issue a periodic account statement, pay attention to what it says. When in doubt, check with personnel in the appropriate office.
Change in status. There are situations where an option initially granted as an ISO loses that status.
- A change in the terms of the option after it’s granted may or may not make it lose ISO status, depending on the nature of the change and the circumstances in which it was made.
- An ISO loses that status three months after you cease to be an employee of the company, although there are situations where a temporary change in employment status won’t have this effect, even if it extends longer than three months.