In many ways, incentive stock options (ISOs), also known as qualified or statutory stock options, are similar to their non-qualified relatives. They are, however, the only ones that permit the participant to report all profit between the exercise and sale price as capital gains if certain requirements are satisfied. In exchange for this benefit, incentive stock options must follow a set of criteria that do not apply to other kinds of schemes. While ISOs are sometimes known as qualified stock options, they should not be confused with ERISA-governed qualified retirement plans.
Except for their tax classification, incentive stock options are structured and designed similarly to non-qualified stock options. The employer still gives an employee the option (the right, but not the responsibility) to acquire a set number of shares of company stock at a fixed price within a specified time frame (in most cases, the price the stock closed at on the grant date). The employee may then exercise the options by acquiring the stock at the exercise price at any time throughout the offering period. He or she may either sell the stock right away and make a fast profit, or he or she can wait and sell the shares later.
Dates and Key Terms
Date of Grant. This is the calendar day on which an employer provides an employee the option to purchase a certain number of shares at the exercise price during the offering period.
Offering Period. This is the time frame in which employees may exercise the options that have been provided to them. This time always starts on the day of grant and ends on the date of expiration. ISOs always have a 10-year offering duration.
Exercise Price. This is the predetermined price at which the employer allows the employee to purchase stock in the plan. This price may be the closing price of the stock on the day of the award, or it may be decided by a formula devised by the employer.
Date of Sale. This is, of course, the calendar day on which the stock is sold, and it is also the second day on which a taxable event occurs for NQSO holders. There may be many sale dates associated with a particular exercise.
Date of Exercise. The exercise date is the calendar day on which an employee exercises the option to purchase stock. As a result, a purchase transaction is always completed on this day. For ISOs, a taxable event occurs on this day only if the gap between the exercise price and the market price becomes a preference item for the Alternative Minimum Tax. Otherwise, the employee has no tax liability on this date.
Clawback. This sort of provision is merely a list of factors that may enable the employer to revoke the options it has given. This clause is often incorporated to safeguard the employer in the event that it becomes financially unable to satisfy its responsibilities to the options.
Date of Expiration. This is the day on which the offering period ends.
Most ISO plans have some kind of vesting schedule that must be met before options can be exercised. It may just require that an employee work for the firm for a set period of time after the award date, or it may include a list of achievements, such as meeting a specified sales or production-related quota. Some plans additionally include an accelerated vesting schedule, which enables the employee to exercise the options immediately if the performance targets are fulfilled before the time aspect of the schedule is completed.
The vesting schedule’s time component might be constructed in one of two ways:
Cliff Vesting. Cliff vesting means that the employee gets instantly vested in all options. This might occur between three and five years after the grant date.
Vesting is graded. This is a plan in which an equal part of the granted options may be exercised each year. This typically begins in year two and continues until year six, with 20% of the options vesting each year.
Taxation of ISOs
ISOs are unique among corporate stock plans in that they are not subject to the same taxation as their non-qualified counterparts. ISOs are the only kind of employee stock plan that permits participants to get capital gains treatment on the whole profit amount between the exercise price and the stock’s sale price. Most other kinds of plans require employees to report the bargain portion received upon exercise as W-2 income, while ISO participants do not.
Considerations for AMT
Taxpayers who receive a considerable amount of income from specific sources, such as tax-free municipal bond income or state income tax refunds, may be required to pay an alternative minimum tax. The IRS enacted this tax to capture taxpayers who may otherwise escape taxation by using specific techniques, such as transferring all of their assets to municipal bonds in order to get solely tax-free income.
The AMT calculation formula is a distinct computation that considers some items of income that would not be taxed on a typical 1040 as income. It also prevents certain standard deductions from being taken. One of them is the bargain factor from exercise in a qualifying ISO disposition, which is treated as an AMT “preference item.” This implies that money that would normally be taxed as a long-term capital gain is treated as regular income for AMT purposes. Participants whose ISO exercises and sales place them in AMT zone may face a much greater tax payment than they would otherwise.
Pros and Cons of ISOs
The Benefits of ISOs
The advantages of ISOs are similar to those of their non-qualified counterparts:
Additional earnings. Employees that get ISOs might raise their overall pay above and beyond their wage.
Deferred taxation. Employees may postpone taxation on their ISOs until they sell the stock, but they may face AMT concerns.
Capital Gains taxation. If the holding periods are satisfied and the exercise does not trigger AMT, all income from ISOs may be taxed as a long-term capital gain.
Improved employee motivation and retention. Employees that earn ISOs are more likely to remain with the firm and work well.
Increased Employee Motivation and Retention
Taxation of Capital Gains Loss Employees who sell their stock as part of a disqualifying distribution may only report the difference between the exercise and sale prices as a capital gain; the remainder is treated as earned income.
Lack of diversification. Employees who get ISOs may become too involved in company stock relative to the rest of their financial portfolios.
Issuance restrictions. Employers are not permitted to award more than $100,000 in ISOs to an employee in a calendar year (valued as of the grant date).
Alternative Minimum Taxation (AMT). In rare situations, the amount of the bargain element at exercise might become a preference item for AMT, which implies that the employee may pay much higher tax on the exercise.
Increased taxes. If the participant does not plan ahead, the sale of ISOs may place him or her in a higher tax bracket for the year, but in certain situations this is inevitable.
There are no tax deductions. Unless the stock is sold in a disqualifying disposition, employers cannot deduct the bargain part of an ISO exercise as compensation received.
There is no withholding. Because employers are not obligated to withhold any form of tax from ISO exercises, employees must keep track of and disclose this aspect of the transaction on their own.