Incentive Stock Options: How They Work

Clients Rate Lawyers on our Platform 4.9/5 Stars
based on 4,036 reviews

Jump to Section

Need help with a legal contract?

Post Project Now

Post Your Project (It's Free)

Get Bids to Compare

 Hire Your Lawyer

What Are Incentive Stock Options (ISOs)?

An incentive stock option (ISO), also known as a qualified stock option, is a form of corporate compensation offered to employees that gives them the option to buy shares of a company’s stock in the future at a predetermined price. ISOs also have the possible tax benefits since they are taxed at the capital gains rate as opposed to the rate for ordinary income.

A private company will use ISOs to incentivize employees beyond normal compensation methods to work hard for the organization and stay for a certain period of time. ISOs are commonly issued to early-stage employees in startups or any highly valued employee at an organization, like top management.

How Incentive Stock Options Work

Incentive stock options allow an individual to buy shares of stock at a set price, also known as the exercise price or strike price, for a specific period of time, regardless of what the shares may be worth in the future. In other words, when you receive ISOs you cannot purchase stock right away.

For example, an employee may be issues ISOs with a strike price of $5 with the option to buy the shares in the future. If the value of the shares in the future is $20, the employee will still be able to buy the shares at $5 per share and have a net profit of $15 ($20 - $5).

Before an employee can purchase shares, ISOs need to vest, which is a legal term that means to ‘earn a right’ to a present or future payment. Employers will set up a vesting schedule, which outlines the amount of time an employee needs to stay at a company in order to earn the right to purchase the ISOs. This is how ISOs can be used as instruments to promote employee retention.

Here is an article on vesting.

Important Terms To Know In ISOs:

  • Number of Shares – The number of shares is the total number of ISO shares the employee is being offered as part of their compensation package. The employee will have the right to buy those shares after they vest.
  • Exercise Price – The exercise price is the price the shares can be purchased for in the future. The price is typically set at some sort of fair market value when the ISOs are being offered.
  • Exercise Method – The exercise method of is the payment method used to purchase the shares. You often see cash as an exercise method but can also see things like stock swaps.
  • Grant Date – The grant date is the date the ISOs were issued or offered to the employee. This is an important date since it is typically used to calculate the expiration date.
  • Expiration Date – The expiration date is when the options will expire and no longer be available for the employee to purchase. This is typically years after the grant date.
  • Vesting Schedule – The vesting schedule lays out the timeline in which the employee gains the right to purchase the shares. You will typically see a ‘one year cliff’ where a certain number of shares vest, or become available to purchase, and then monthly or quarterly vesting thereafter.
  • “One Year Cliff” – A ‘one year cliff’ is a standard term in vesting schedules, which means if an employee leaves within one year of ISOs being issued, they will forfeit their right to purchase any shares. If an employee stays beyond a year, a certain number of shares vest.

Not all employee stock purchase plans (ESPP) are created equally. Below are some wants incentive stock options compare vs ESPP.

Incentive Stock Options (ISOs) vs. Nonqualified Stock Options (NSOs)

Many people want to know the difference between ISOs, also known as ‘qualified stock options’, and Non-qualified Stock Options (NQSOs). Here are two main differences:

  • Non-qualified Stock Options do not qualify for preferential tax treatment. ISOs do qualified for preferential tax treatment. NQSOs are taxed at the ordinary income rate while ISOs are taxed at the capital gains rate.
  • Non-qualified Stock Options can be given to non-employees, like contractors and consultants. ISOs can only be issued to employees.

Here is an article on the different types of employment.

Meet some lawyers on our platform

Zachary J.

53 projects on CC
View Profile

Don G.

27 projects on CC
View Profile

Daniel R.

10 projects on CC
View Profile

Kristen R.

40 projects on CC
View Profile

Incentive Stock Options vs. Restricted Stock Unites (RSUs)

Below are three main differences between incentive stock options vs RSUs:

  • ISOs provide the employee the right to buy shares at a specified price. RSUs are structured so the employee receives a certain number of shares after being at a company for a certain amount of time. The difference being that RSUs are more than an option – they are issued no matter what.
  • When an employee receives their RSUs and they vest, the employee does not need to make payment to purchase the stock. With ISOs, you need to purchase the shares at the exercise price.
  • When RSUs vest, they become taxable. ISOs are only taxable when you sell the stock.

Here is an article about restricted stock.

ContractsCounsel Incentive Stock Options Image

Image via Pexels by energe.pic

Incentive Stock Options Tax

ISOs receive more preferential tax treatment than any other form of stock compensation for employees. This is one of the reasons why they are popular. ISOs are taxed at the capital gains rate if the below two conditions are met:

  • Shares are held by the shareholder for more than one year from the date of exercise
  • Shares are held by the shareholder for two year from the time of the grant

If these two conditions are met, profits are taxed at the capital gains rate as opposed to the normal income rate.

For example, if a company grants 1,000 shares of ISOs to an employee on January 1, 2001 and are bought at the exercise price on January 1, 2003, the employee would need to hold on to the shares till January 1, 2004 to be able to qualify for capital gains tax. Both conditions are met since the employee has held the shares for a minimum of two years from the time of grant (January 1, 2001) and held the shares for a year from the date of exercise (January 1, 2003).

Here is an article that breaks down the math for different situations related to taxes and how to value your ISOs.

Get Free Bids to Compare

Leverage our network of lawyers, request free bids, and find the right lawyer for the job.

Get Bids Now

Planning For Alternate Minimum Tax (AMT)

Exercising your incentive stock options may trigger the alternative minimum tax, or AMT. This tax is levied on filers who high levels of certain amounts of income, such as ISO bargain elements. AMT is designed to make sure the filer pays at least a minimum amount of tax on income that would otherwise be tax fee.

It is best to consult a tax lawyer to make sure you plan for AMT.

Who Can Get Incentive Stock Options

If you decide you want to gran ISOs or negotiate to try and receive ISOs, you should know the who qualifies and what their limitations are. Incentive stock options can only be issued to employees of a company. Contractors, consultants, and board members are not eligible for ISOs, but are eligible for non-qualified stock options and other types of employee stock purchase plans.

Here is an article that discusses the qualifications and limitations of ISOs.

Gets Your Incentive Stock Options Reviewed By ContractsCounsel

Need help understanding or analyzing your incentive stock options? Post your project to ContractsCounsel for free and receive proposals from attorneys today who specialize in employee stock purchase plans.

How ContractsCounsel Works
Hiring a lawyer on ContractsCounsel is easy, transparent and affordable.
1. Post a Free Project
Complete our 4-step process to provide info on what you need done.
2. Get Bids to Review
Receive flat-fee bids from lawyers in our marketplace to compare.
3. Start Your Project
Securely pay to start working with the lawyer you select.

Meet some of our Lawyers

Keidi C. on ContractsCounsel
View Keidi
5.0 (7)
Member Since:
August 25, 2021

Keidi C.

Principal Attorney
Free Consultation
Get Free Proposal
Boston, MA
25 Yrs Experience
Licensed in MA, NY
New England Law | Boston

Keidi S. Carrington brings a wealth of legal knowledge and business experience in the financial services area with a particular focus on investment management. She is a former securities examiner at the United States Securities & Exchange Commission (SEC) and Associate Counsel at State Street Bank & Trust and has consulted for various investment houses and private investment entities. Her work has included developing a mutual fund that invested in equity securities of listed real estate investment trusts (REITs) and other listed real estate companies; establishing private equity and hedge funds that help clients raise capital by preparing offering materials, negotiating with prospective investors, preparing partnership and LLC operating agreements and advising on and documenting management arrangements; advising on the establishment of Initial Coin Offerings (ICOs/Token Offerings) and counseling SEC registered and state investment advisers regarding organizational structure and compliance. Ms. Carrington is a graduate of Johns Hopkins University with a B.A. in International Relations. She earned her Juris Doctorate from New England Law | Boston and her LL.M. in Banking and Financial Law from Boston University School of Law. She is admitted to practice in Massachusetts and New York. Currently, her practice focuses on assisting investors, start-ups, small and mid-size businesses with their legal needs in the areas of corporate and securities law.

Michael O. on ContractsCounsel
View Michael
5.0 (4)
Member Since:
February 14, 2022

Michael O.

Managing Attorney
Free Consultation
Get Free Proposal
Los Angeles
16 Yrs Experience
Licensed in CA, NY
University of Southern California

A corporate and commercial attorney with experience in transactional legal services including corporate and finance transactions, mergers and acquisitions, real estate, commercial contracts, bankruptcy, restructuring, international business transactions and general counsel services. Additional background skills and experience include investment banking, financial analysis, and commercial litigation. Sectors covered include technology, media, franchises, and business services providers, from start-ups to medium and large enterprises.

Namrita N. on ContractsCounsel
View Namrita
4.9 (11)
Member Since:
August 18, 2021

Namrita N.

Attorney at Law
Free Consultation
Get Free Proposal
Plano, TX
3 Yrs Experience
Licensed in MN, TX
Mitchell Hamline School of Law

Retired Dentist transitioned to Law, with a special interest in Commercial Real Estate, Startup businesses, Asset Purchase Agreements, and Employment Contracts. I love to help dentists and physicians with legal issues pertaining to licensing, credentialing, employment, and general business-legal questions.

T. Phillip B. on ContractsCounsel
View T. Phillip
4.8 (5)
Member Since:
August 10, 2021

T. Phillip B.

Free Consultation
Get Free Proposal
27 Yrs Experience
Licensed in IL
Drake University Law School

Attorney creating plans and strategies to help individuals create, build, protect and pass on wealth.

Robert Jay H. on ContractsCounsel
View Robert Jay
Member Since:
August 4, 2021

Robert Jay H.

Free Consultation
Get Free Proposal
New York, NY
42 Yrs Experience
Licensed in NY
New York University School of Law

My Legal career hasfocused on representing businesses (corporations and limited liability companies) as general outside counsel. In this capacity, I have drafted a broad range of legal documents as well as analyzed proposed agreements drafted by the other party's attorney to the agreement for the pupose of determining the risks to which my client would be exposed. I maintained the client's minute book if no one in-house was available for that task. Additionally, if rquested, I served as a general advisor to the client's executive offers and to its Board of Directors.

Simon C. on ContractsCounsel
View Simon
Member Since:
August 5, 2021

Simon C.

Corporate Attorney
Free Consultation
Get Free Proposal
19 Yrs Experience
Licensed in UT
Brigham Young University Law School

Corporate counsel with years of in-house experience working with and reporting to board / executive-level and upper management, along with extensive regional / national law firm background in commercial transactions and contracts, complex commercial litigation, and employment matters. Skilled at executing corporate priorities, driving profitability by implementing goal-oriented processes to achieve revenue and productivity targets, and managing company litigation and outside counsel. Recognized for creating policies and practices to address ethical dilemmas and resolving misconduct.

Jim S. on ContractsCounsel
View Jim
Member Since:
August 13, 2021

Jim S.

Free Consultation
Get Free Proposal
37 Yrs Experience
Licensed in NY
Notre Dame

Jim Slattery most recently served as General Counsel at Regional News Network, a large owner of broadcast television stations. Jim is an experienced attorney with broad-based expertise. He is a seasoned negotiator who has been involved in negotiations as complex as the Olympic Games. Jim spent 18 years as Vice President for Business and Legal Affairs at NBCUniversal. Previously, Jim worked in the media industry in various roles at All American Television. Jim’s success can be attributed to his ability to properly analyze data, manage projects, lead teams, develop creative solutions for complex problems, focus on strategically optimizing assets, manage/allocate risk and collaborate with divergent constituent groups to achieve objectives. Jim received a J.D. and a B.B.A. from the University of Notre Dame.

Jonathan H. on ContractsCounsel
View Jonathan
Member Since:
September 18, 2021

Jonathan H.

Free Consultation
Get Free Proposal
New York
11 Yrs Experience
Licensed in NY
Pace Law School

I’m an attorney focusing my practice on concierge corporate and intellectual property law for startups and high-growth companies. I also serve as outside General Counsel to several businesses in various sectors. Since founding my practice I've worked with hundreds of clients across a variety of industries. My experience as a former General Counsel of a premier edtech company gives me unique insight into the challenges my clients face and how to resolve them efficiently and cost-effectively.

George F. on ContractsCounsel
View George
Member Since:
August 18, 2021

George F.

Free Consultation
Get Free Proposal
Astoria, NY
22 Yrs Experience
Licensed in NY
Fordham University School of Law

The Law Office of George K. Fuiaxis, from the very beginning in 2002, has built a reputation with its clients as an unmatched, diligent, hands on law practice that is always on duty to find the best course of action for its clients. With a supreme pledge of exceptional service to its clients in the areas of Real Estate (Commercial & Residential), Loan Modifications, Intellectual Property, Corporate Law & Business Transactions, Wills, Trusts & Estates, the Law Office of George K. Fuiaxis creates solutions for the many faceted problems faced by its clients. The office represents several various clients, including well known lending institutions, foreign and domestic corporations, sellers and buyers of residential and commercial real estate, residential and commercial landlords and tenants, well known restaurant and business owners, automobile dealerships, airline companies, well known fashion, sports and entertainment industry individuals and corporations, information technology (IT) startups and well known IT companies.

Chris J. on ContractsCounsel
View Chris
Member Since:
August 22, 2021

Chris J.

Outside Counsel
Free Consultation
Get Free Proposal
Irvine, CA
28 Yrs Experience
Licensed in CA
Loyola Law School, Los Angeles

I'm a business law generalist with over 24 years of experience, including as in-house General Counsel, as outside counsel through my own firm and as an attorney in an Am Law 100 law firm. My employers and clients uniformly appreciate my ability to (i) negotiate and close transactions quickly and effectively, and (ii) to make the complex simple. Among other things, I can efficiently assist you on entity formation, governance, and structure; HR issues; mergers and acquisitions; and the negotiation and drafting of all types of commercial contracts. I'm the proud recipient of multiple Martindale-Hubbell Client Distinction Awards given only to the top 5% of attorneys for quality of service.

Gregory W. on ContractsCounsel
View Gregory
Member Since:
August 23, 2021

Gregory W.

Business Attorney
Free Consultation
Get Free Proposal
Los Angeles
16 Yrs Experience
Licensed in CA
University of West Los Angeles

Strategic thinking business minded Outside General Counsel here to help you with your company. I have been able to help guide business owners from startup through series A, B, & C funding and ultimately IPO's. Regardless of your plans I am here to help you succeed as you grow your business.

Find the best lawyer for your project

Browse Lawyers Now

Want to speak to someone?

Get in touch below and we will schedule a time to connect!

Request a call