Incentive stock options (also commonly known as ISO stock options or simply ISOs) are stock options offered to key employees and top-tier management. Incentive stock options can receive preferential tax treatment. Employees offered incentive stock options are able to purchase company stock at a lower price for a period of ten years after they are offered. This allows employees to take advantage of the stock's appreciation for an immediate profit. Incentive stock options are an important benefit that qualifying employees may exercise in order to purchase stock with tax advantages and built-in discounts.
While there are advantages to ISO stock options compared to the more traditional NSOs, incentive stock options must meet very specific conditions to be legal. Conferring with a corporate securities lawyer in the Priori network will help you decide whether incentive stock options are the right choice for your company and can help you comply with all related regulations.
Key Terms to Know
When dealing with incentive stock options, companies should understand the following terms:
- Grant Date. This is the date an employer grants an employee the option to buy a set number of shares at a specific exercise price.
- Exercise Price. This is the preset price at which the employee can buy incentive stock options. Generally, a specific formula determines this price, but some incentive stock options simply set the exercise price as the closing price of the stock on the grant date.
- Offering Period. This is the timeframe within which the employee can purchase incentive stock options under the plan offered to that employee.
- Expiration Date. This is the date upon which the offering period ends and the incentive stock options are no longer available to the employee.
- Exercise Date. This is the date an employee exercises their incentive stock options and a purchase transaction takes place.
- Sale Date. This is the date the employee sells the incentive stock options. The sale date can be the same as the exercise date.
- Clawback Provision. This provision lists the conditions under which the employer can take back the incentive stock options issued. Clawback provisions are intended to protect the employer if the company becomes unable to meet its incentive stock option obligations.
- Bargain Element. This is the difference between the exercise price of the incentive stock option and the market price at which it is exercised.
- Cliff Vesting. This is the typical way that incentive stock options vest. Under this setup, the employee becomes immediately vested in all of the incentive stock options, usually three years after the grant date.
- Graded Vesting. This is another way that incentive stock options vest. Under this setup, an equal portion of the options granted can be exercised each year, usually 20 percent per year for five years, starting the second year after the grant date.
- Qualifying Disposition. This term relates to the taxation of incentive stock options. An incentive stock option is considered a qualifying disposition, and it is therefore not taxed as income, if it was disposed more than two years after the grant date and more than one year after the exercise date, as long as the taxpayer was continuously employed by the employer granting the incentive stock option from the grant date up to no more than three months prior to the exercise date.
- Disqualifying Disposition. A disqualifying disposition is any disposition that is not considered a qualifying disposition. If the incentive stock option is exercised in any manner that does not make it a qualifying disposition, it is considered a disqualifying or nonqualifying disposition and is generally taxed as income.
Incentive Stock Options, Tax Considerations, and Qualifying Dispositions
Unlike other types of employee stock options, incentive stock options are not taxed as regular income using a W-2. Qualifying dispositions of ISOs are taxed as a capital gain at the long-term capital gains tax rate on the difference between the selling price and the cost of the option. This generally saves the employee a significant amount of money, making incentive stock options the most tax-friendly employee stock option. It is important to remember, however, that employees can only receive this favorable tax treatment by taking on additional risk and holding the incentive stock options longer so that they are considered qualifying dispositions.
Advantages of Incentive Stock Options
There are three major benefits of ISOs for companies and employees:
- Additional income under a more favorable tax scheme. ISOs became popular because of their tax benefits. Specifically, ISOs may be considered qualifying dispositions, ensuring that they are taxed as long-term capital gains rather than income.
- Enhanced employee retention. Because the employees must stay employees in order to exercise incentive stock options, ISOs help companies retain key employees.
- More engaged and motivated key employees. The main advantage of ISOs is that they align the interests of employees and management with shareholders by giving employees an extra incentive to grow the company.
Disadvantages of Incentive Stock Options
There are three important disadvantages of ISOs that companies and employees should consider before exercising incentive stock options:
- Higher tax burdens and Alternative Minimum Tax considerations. Sometimes the gains made through incentive stock options or the tax responsibility through the Alternative Minimum Tax leave the employee owing more taxes than expected or in a higher tax bracket than planned. For more information on how the Alternative Minimum Tax relates to ISOs, see the FAQ section below.
- Limits on issuance. Companies may only issue $100,000 worth of incentive stock options to an employee in a single year.
- More risk. Because employees must hold onto incentive stock options for an extended period of time before vesting, they bear more risk than if the company issues the employee NSOs. Some also argue that incentive options encourage risky management behavior because managers theoretically only have upside potential, while shareholders bear all downside risk.
The cost of creating an incentive stock option plan can vary significantly based on your needs. Priori attorneys typically charge approximately $150 per hour to $450 per hour for this type of work. In order to get a better sense of cost for your particular situation, put in a request to schedule a complimentary consultation and receive a free price quote from one of our lawyers.
What is the difference between ISOs and NSOs?
ISOs and NSOs (also known as NQOs) are both types of employee stock options, but they are taxed differently. Incentive stock options are taxed as capital gains at a lower rate, while NSOs are generally taxed as a part of regular compensation under the ordinary federal income tax rate. In addition, incentive stock options are generally limited to executives and other key employees, while NSOs are available to any staff member. Finally, ISOs are capped; employees can vest only $100,000 each year. NQOs have no such cap.
What is the Alternative Minimum Tax (AMT) and how does it relate to incentive stock options?
The Alternative Minimum Tax is a provision of the tax code designed to ensure that higher-income taxpayers do not pay a disproportionately small amount in taxes by taking a variety of tax deductions and exclusions. The Alternative Minimum Tax is a separate calculation and is paid in addition to the taxpayer's regular tax obligation. When calculating the Alternative Minimum Tax, certain deductions, called preference items, are added back in, certain forms of income not considered under the regular tax scheme may be considered, and tax rates differ from regular tax rates. The spread on an incentive stock option is a preference item--an item that may be deducted under the regular tax code that is added back in for the purposes of Alternative Minimum Tax calculations. In other words, when employees exercise ISOs, they may owe taxes under the Alternative Minimum Tax. If you are concerned about this liability, consult a tax attorney from the Priori network.