Employer-sponsored stock compensation plans are either qualified or nonqualified. The key distinction between the two is the tax consequences to employer and employee. With a qualified plan, the employer is generally allowed a deduction when a contribution is made to the plan, and the employee is not taxed until a distribution is made from the plan, presumably upon retirement at some point in the future. With a nonqualified arrangement, the employer will receive a deduction when the employee recognizes income. Under these plans, the employer makes contributions to a trust, which is used to purchase the employer's stock, thus giving the employees an ownership interest in the company.
Nonqualified plans are either statutory or nonstatutory.
Unlike qualified plans, nonqualified plans do not have antidiscrimination rules or limits on the amount of contributions. Likewise, penalty taxes, which may apply to qualified plans for early withdrawals and excess balances, do not apply to nonqualified plans. Furthermore, there are estate advantages to owning company stock that will receive a step-up in basis upon the owner's death, as opposed to stock owned as part of a pension or IRA, which most likely will be subject to ordinary income tax rates. The employee will not recognize any income on the grant date of an ISO because of the IRS requirement that the option price must equal the stock's FMV on the grant date. When the option is exercised, the employee pays the specified option price and becomes the owner of the ISO stock.