Is it better to be granted nonqualified stock options (NQSOs) or incentive stock options (ISOs)?
The answer depends on your comfort level with tax complexity and risk. However, understand first that you may be eligible to receive only nonqualified stock options (NQSOs) to begin with. Many companies find incentive stock options (ISOs) not worth the administrative complications, and under the rules of the tax code they cannot be granted to nonemployees, such as directors, consultants, and contractors. For an explanation of the differences between NQSOs and ISOs, see the article Stock Options Made Simple: Comparing NQSOs And ISOs elsewhere on this website.
Incentive Stock Options: More Complex
Whether one type of option is better than the other depends on what you do with the shares that you acquire at exercise and whether you feel comfortable with the complexities of the alternative minimum tax (AMT), which can apply to ISOs. If you immediately sell the shares at exercise, the taxation is essentially the same (i.e., all ordinary income on the spread), though there is no tax-withholding or payroll tax with ISOs (see the FAQ on the tax consequences of selling ISO shares in the year of exercise).
ISO Taxation Offers Benefits But Also Presents Risks
If you plan to hold the shares, some tax benefits exist with ISOs (as long as the stock continues to appreciate). If you hold the shares for more than one year after exercise and two years after grant, ISOs can provide favorable long-term capital-gains tax treatment on all the stock-price appreciation at sale over the exercise price (see the related FAQ).
But if the stock price of a company's shares underlying an ISO appreciates significantly before (rather than after) exercise, an ISO exercise can generate alternative minimum tax (AMT). To pay that liability, you may be forced to sell some of your shares in a so-called "disqualifying disposition" of the ISO shares. This gives rise to ordinary income in much the same way that the exercise of an NQSO would, though taxes on this ordinary income are not withheld by the company. You also may be stuck with paying AMT on the spread at exercise even though the stock price at tax time is much lower (see a related FAQ).
If you make a disqualifying disposition of an ISO, the sale of the ISO shares does not give rise to wages for Social Security and Medicare purposes as would the exercise of an NQSO. This ends up saving you and your employer at least the Medicare portion of the Social Security tax of 1.45% each on the spread at exercise of an ISO, if you are already over the yearly maximum for Social Security.
We cannot stress enough that in a volatile stock market ISOs require you to plan for AMT, which is discussed in detail by other FAQs and articles. For details on the tax reporting for ISOs, see the relevant area of the section Reporting Company Stock Sales in the Tax Center.
For a comparison of ISOs and NQSOs from your company's perspective, see another FAQ.