Incentive Stock Options: How They Work

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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.

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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.

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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.

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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.

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