According to the U.S. Bureau of Labor Statistics, the U.S. unemployment rate rose slightly to 3.7% in October. Seeing as how that’s still a relatively low number, your business may be struggling to fill its open positions.

Offering equity-based compensation to job candidates is one recruitment strategy to consider. Many companies have used stock options to attract, retain and motivate executives and other key employees.

The finer points of ISOs

Stock options confer the right to buy a certain number of shares at a fixed price for a specified time. Typically, they’re subject to a vesting schedule. This requires recipients to stay with the company for a certain amount of time or meet stated performance goals.

Incentive stock options (ISOs) offer attractive tax advantages for employees. Unlike nonqualified stock options (NQSOs), which we’ll discuss below, ISOs don’t generate taxable compensation when they’re exercised. The employee isn’t taxed until the shares are sold. And if the sale is a “qualifying disposition,” 100% of the stock’s appreciation is treated as capital gain and is free from payroll taxes.

To qualify, ISOs must meet certain requirements:

  • They must be granted under a written plan that’s approved by shareholders within one year before or after adoption,
  • The exercise price must be at least the stock’s fair market value (FMV) on the grant date (110% of FMV for more-than-10% shareholders), and
  • The term can’t exceed 10 years (five years for more-than-10% shareholders).

Additionally, the options can’t be granted to nonemployees. What’s more, employees can’t sell the shares sooner than one year after the options are exercised or two years after they’re granted.

And the total FMV of stock options that first become exercisable by an employee in a calendar year can’t exceed $100,000.

How NQSOs differ

NQSOs are stock options that don’t qualify as ISOs. Typically, the exercise price is at least the stock’s FMV on the grant date. (Various tax complications may ensue, which we won’t get into here.) The NQSO itself generally isn’t considered taxable compensation because there’s no taxable event until exercise. At that time, the spread between the stock’s FMV and the exercise price is treated as compensation.

Although NQSOs are taxed as ordinary income upon exercise, they have several advantages over ISOs. First, they’re not subject to the ISO requirements listed above, so they’re more flexible. For example, they can be granted to independent contractors, outside directors or other nonemployees. Second, they generate tax deductions for the employer and don’t expose recipients to liability for the alternative minimum tax.

Look before you leap

If you’re considering equity-based compensation, it’s important to review the pros, cons and tax implications before offering either type of stock option.

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