In this lesson, you will learn what an incentive stock option is and how it differs from other employee stock options.
Incentive stock options (ISOs) are a type of employee stock option that may receive special tax treatment. They are favored as incentives for highly paid employees for the potential tax savings.
ISOs achieve tax savings by meeting the fairly strict requirements outlined in the tax code. Basically, ISOs shift the tax on options from ordinary income, as is the case with nonqualified stock options, to capital gains tax.
The current capital gains tax rate is 20 percent, considerably lower than the normal ordinary income tax rate for highly paid individuals. The second lowest income tax bracket is 28 percent.
ISOs have some special rules that must be followed to receive the favorable tax treatment:
You must hold stock from ISOs more than one year after the exercise date and two years after the grant date.
The grant date is the date the options are issued. There may be a vesting period that follows the grant date. The exercise date is the date when the employee converts the options to stock. This date can be any time after the grant date and any vesting requirements. The employee has until the options expire at the end of the term to exercise the options.
An ISO's exercise price must at least equal the fair market value of the underlying stock when the grant is issued.
Shareholders must approve the ISO plan.
ISOs are available to employees only.
Employees owning 10 percent or more of the voting stock are not eligible for ISOs except under certain conditions.
Caution
Incentive stock options have some fairly strict guidelines for receiving tax-favored status. You must follow these rules. The company can't change them because the rules are defined in the tax code. No matter what the company says, if the plan does not adhere to the tax code, it will lose its tax-favored status.
These are the major points, but not a complete list. Check with the plan administrator with specific questions. Let's look at a couple of the major provisions of ISOs.
The holding period for ISOs is one of the most critical tests for tax-favored treatment. These rules fix a certain holding period for stock from the ISOs and that makes them attractive to employers that want to keep top employees motivated to stay with the company.
The general rule is the employee must hold the stock from an ISO for at least one year from the exercise date. The current tax code sets one year as the minimum holding period to qualify for long-term capital gains rates.
The employee must also hold stock from an ISO for two years from the grant date. These two requirements mean the earliest an employee could sell stock bought through an ISO is two years after the grant date.
Here are some dates to keep track of:
A schedule that considers these two dates reveals the earliest time the stock can be sold and qualify for favored tax treatment. Here's how it looks:
In this case, the employee exercises the option immediately, but must hold the stock for two full years to meet the holding requirement. Since an ISO's exercise price must equal or exceed the fair market value of the underlying stock on the grant date, this scenario is unlikely.
Tip
Incentive stock options are rarely exercised when granted because they are issued at fair market value of the underlying stock. It would not make much sense to exercise at this point.
Let's look at another example:
In this example, the employee chooses not to exercise the ISO until June 1, 2001. The earliest possible qualifying sale date is one year and one day past the exercise date, since the two-year holding requirement from grant date is met on January 1, 2002.
If these holding periods are not met, the ISO automatically becomes a nonqualified stock option and the employee will owe ordinary income tax on the difference between the exercise price and the fair market value of the stock at exercise.
Top personal income tax rates at the time of this writing were 39.6 percent and long-term capital gains rates are 20 percent. A miscue on the timing could cost the employee twice the tax bite.
The tax code says the exercise price can't be less than 100 percent of the fair market value of the underlying stock.
Unlike nonstatutory stock options, there are no discounting ISO exercise prices. This will be even more important when we look at employee stock options and the initial public offering in Lesson 10, "Taxes and Your Options."
Caution
Exercising ISOs and selling the stock involves important timing issues. Be sure you understand the holding period rule.
The code does not prohibit an employer from setting the exercise price over the fair market value of the underlying stock at grant issue, although it would defeat some of the purpose of ISOs, which is to provide incentives for key managers to stay on the job. Granting them a worthless option would be counterproductive.
There is a condition, however, when the option's exercise price must exceed the fair market value of the underlying stock. If the employee owns 10 percent or more of the voting stock, then he can only receive ISOs with an exercise price of at least 110 percent of the fair market value of the underlying stock on the date of grant issue.
On top of that, the options may not be exercisable for more than five years after the date of the grant issue. These are the conditions under which owners of 10 percent or more of the stock can receive ISOs. Your legal counsel will undoubtedly explain this in more detail if you fall into this ownership category.
Incentive stock options are popular with highly paid managers; however, they come with some restrictions and conditions, as listed below:
Shareholder approval is required to issue ISOs. That approval must come within 12 months of plan adoption.
Employees must receive a written ISO agreement that spells out any restrictions placed on exercising the options, the grant price, and term of the option.
ISOs must have a grant term of 10 years or fewer.
ISOs can be for any class of stock in the company. ISOs can be for voting, nonvoting, restricted, and special shares for employees only.
Tip
Some employers issue a special class of stock just for employee stock options. This may make their marketability suspect on an open exchange.
ISOs are for employees only. No outside directors, contractors, or other nonemployees are eligible.
Employees can't transfer ISOs to anyone else except in the case of death.
Exercising ISOs for the first time has special rules. They can't exceed $100,000 fair market value as of the grant date.
The employer can include other provisions in an ISO as long as those provisions do not violate any of the tax code requirements.
Employers and employees favor ISOs for several reasons, but their flexibility is one of the most important.
Incentive stock options allow employers to structure compensation for key employees that can be tailored to each worker. It is not unusual for each key employee to have his own ISO plan structured to meet his needs.
This gives ISOs an advantage over traditional compensation plans, such as qualified retirement plans, which must be made available to all employees and may have strict restrictions on participation by highly paid executives.
Plain English
Qualified retirement plans qualified retirement plans are authorized by the tax code and allow money to be saved with no taxes due until withdrawals begin, usually at age 65. Pension plans, 401(k) plans, and individual retirement accounts (IRAs) are examples of qualified retirement plans.
Companies can also structure an ISO so that the employee puts his money at risk when exercising or the company can set up financing plans that help the employee pay for exercising the ISOs.
Along with these benefits, ISOs carry the traditional benefits associated with employee stock options. The executive has unlimited potential gain and minimal tax liability if the company is successful. It is easy to see why ISOs are so popular.
Employers find them particularly helpful in recruiting and retaining top talent. Cash-starved startups, particularly in the high-tech industries, use ISOs to attract and retain executives they could not afford with cash compensation only.
ISOs, if they are handled correctly, are very attractive to highly paid employees. Employees have no tax liability until the stock acquired through an ISO is sold.
This feature distinguishes ISOs from nonstatutory stock options. ISOs must follow a strict timeline from grant date through disposition of the stock bought with the options.
We have already touched on this timeline, but it is worth repeating. Stock bought through exercising an ISO must be held for one year from the exercise date and two years from the grant date to qualify for tax-favored treatment.
Employers must grant ISOs for at least the fair market value of the underlying stock (see the ISO Rules section earlier in this lesson), therefore it is unlikely an employee would exercise the options immediately. The effect of granting ISOs at fair market value and the holding period requirements is to push the benefits employees can recognize into the future at least two years.
Employers that grant ISOs at regular intervals keep advancing more incentives into the future, which is just what they hope will keep the executive on board to realize those future gains and benefit the company at the same time.
ISOs give the employee participation in the growth of the company's stock and very favorable tax consequences when stock acquired through the option is sold.
The bad news is if you violate any of the ISO tax code requirements, the tax bite can be terrific. You'll be liable not only for the difference between the exercise price and the fair market value at exercise, but also for any gain in the stock's price when you sell it.
Depending on your timing, both of these gains could be at ordinary income tax rates rather than at the lower capital gains rate. As noted previously, that could be a difference between 39.6 percent and 20 percent in taxes. For example:
Your employer grants 100 ISOs on January 1, 2000, with an exercise price of $20 per share. On June 1, 2001, you exercise those options at a fair market price of $40 per share. On December 1, 2001, you sell the shares for $50 per share.
Is this a qualified disposition? The answer is no because the shares were not held for two years from the grant date and were sold sooner than one year after exercise. Either one of these violations disqualifies the disposition and you owe ordinary income tax on both gains.
Plain English
Disposition refers to the sale of stock acquired through an ISO, although the tax code acknowledges transfers, gifts, or exchanges.
The second example meets the holding period test. The stock was held longer than one year after exercise and two years after the grant date.
In Example 1, you could be liable for ordinary income tax on the difference between the grant price and the fair market value of the stock at disposition:
$20 per share | |
Disposition price of stock: | $50 per share |
Tax liability: | $30 per share, or $3,000 ($30 × 100 shares) |
Ordinary income tax at 39.6%: | $1,188 |
In Example 2, your liability would be capital gains tax on the difference between the grant price and the fair market value of the stock at disposition:
$20 per share | |
Disposition price of stock: | $50 per share |
Tax liability: | $30 per share, or $3,000 ($30 × 100 shares) |
Capital gains tax at 20%: | $600 |
Meeting the holding period requirement saves you $588 in tax ($1,188 - $600 = $588). Another way to look at it is, violating the holding period requirement will cost you almost one-half of your profit.
ISOs incur no tax liability when exercised. Only when stock is sold does the employee face a tax consequence.
Caution
The tax code identifies the Alternative Minimum Tax, which addresses the situation where a taxpayer takes advantage of more tax-favored investments than is allowed.
However, if the employee falls into the Alternative Minimum Tax (AMT) situation, certain events in the cycle of granting and exercising ISOs may trigger AMT consequences.
The AMT situation requires specific guidance from a tax professional. You should consult your tax counselor before exercising an ISO or selling any stock.
Incentive stock options are especially valuable in recruiting and retaining highly paid executives.
Employees must meet specific holding period rules for ISOs to receive tax-favored treatment.
Your profits from stock bought with ISOs are taxed at favorable long-term capital gains rates.
Gains realized by ISOs that do not meet tax code requirements are taxed at ordinary income tax rates.