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Companies frequently have to confront this question: should they grant nonqualified stock options (“NQOs”) or incentive stock options (“ISOs”) to their employees? (ISOs cannot be granted to non-employee consultants or directors.) For the differences in the tax treatment of different types of equity awards, see the below table.

I generally recommend that private companies issue NQOs rather than ISOs for a variety of reasons. Let me tell you why:

1. NQOs are simpler than ISOs. Simpler is not always better, but it frequently is better. How are NQOs simpler than ISOs? Well, for one, ISOs have more complex holding period requirements to qualify for their advertised benefits than NQOs have. Another reason NQOs are simpler than ISOs: the spread on the exercise of an ISO is an alternative minimum tax (“AMT”) adjustment, requiring an employee to consult with his or her personal tax advisor to completely ascertain and appreciate the magnitude of the tax consequences of exercise. The spread on the exercise of a NQO does not involve a foray into the alternative minimum tax, which is a complex minefield. Employees frequently underestimate the impact of the AMT. In fact, many, many taxpayers get in trouble with the AMT through the exercise of ISOs. Employees exercise ISOs, and then when their taxes are calculated at tax return time, they discover that they owe more in taxes than they can pay. This problem got so bad after the dot-com bubble that Congress passed a special tax act relieving people of AMT liability for ISO exercises that they couldn’t pay–but it was only a one-time tax reprieve. I would be very surprised if Congress ever did this again. This problem of employees not realizing the tax liability they are creating on the exercise of a stock option isn’t very likely to occur with NQOs because tax withholding is due on exercise. For this reason, I say that NQOs are more transparent than ISOs.
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2. The tax consequences of NQOs are easier to determine than the tax consequences of ISOs. NQOs are subject to ordinary income and employment taxes on exercise. Tax withholding is required. You calculate the tax withholding on exercise, and it is determinable with little difficultly. An optionee does not have to try to run mock tax returns to determine the tax impact of the AMT adjustment, which is a good idea for an optionee at the time of an ISO exercise.
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3. The tax consequences of ISOs are frequently misunderstood. People frequently believe that ISOs only have favorable tax consequences, and forget that on exercise the spread is an AMT adjustment which can give rise to very significant tax payment obligations.
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4. The tax consequences of ISOs are frequently far less favorable than anticipated. The AMT consequences of an ISO exercises can result in a significant tax being owed. Many people have made the mistake of exercising ISOs only to discover when it came time to pay their taxes that they owed more in taxes than they could pay.
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5. The primary potential tax benefit of ISOs is actually not very frequently realized. To qualify for the primary tax benefit of an ISO–capital gain tax treatment on the sale of the ISO stock–an optionee has to meet two holding periods. An optionee must hold the stock for one year from the date of the exercise of the option, and for two years from the date of the grant of the option. Very frequently employees never satisfy these holding period requirements because they wait to exercise their options until in connection with a liquidity event, and thus don’t qualify for the one of the primary purported ISO tax benefits–a capital gain on ultimate sale of the ISO stock.
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6. ISOs are not tax deductible to the employer. The spread on the exercise of an NQO is tax deductible to the employer. The spread on the exercise...