What Are Incentive Stock Options (ISOs) – Taxation, Pros & Cons

Immediate dilution of EPS for total shares granted. How many options are available to be sold in the future. To encourage employees to stick around and help the company grow, options typically carry a four to five year vesting period, but each company sets its own parameters. If the employee does not hold the stock for the required holding periods before selling it, then the sale becomes a disqualifying disposition. There are several types of stock purchase plans that contain these features, such as non-qualified stock option plans.

Once the options are exercised, the employee has the freedom to either sell the stock immediately or wait for a period of time before doing so. Unlike non-statutory options, the offering period for incentive stock options is always 10 years, after which time the options expire.

What Are Incentive Stock Options (ISOs)?

However, the employee must meet certain obligations in order to receive the tax benefit. There are two types of dispositions for ISOs:. Just as with non-statutory options, there are no tax consequences at either grant or vesting. However, the tax rules for their exercise differ markedly from non-statutory options. An employee who exercises a non-statutory option must report the bargain element of the transaction as earned income that is subject to withholding tax.

ISO holders will report nothing at this point; no tax reporting of any kind is made until the stock is sold. If the stock sale is a qualifying transaction , then the employee will only report a short-term or long-term capital gain on the sale. If the sale is a disqualifying disposition , then the employee will have to report any bargain element from the exercise as earned income.

Say Steve receives 1, non-statutory stock options and 2, incentive stock options from his company. It should be noted that employers are not required to withhold any tax from ISO exercises, so those who intend to make a disqualifying disposition should take care to set aside funds to pay for federal, state and local taxes , as well as Social Security , Medicare and FUTA. Although qualifying ISO dispositions can be reported as long-term capital gains on the IRS form , the bargain element at exercise is also a preference item for the alternative minimum tax.

This tax is assessed to filers who have large amounts of certain types of income, such as ISO bargain elements or municipal bond interest, and is designed to ensure that the taxpayer pays at least a minimal amount of tax on income that would otherwise be tax-free.

This can be calculated on IRS Form , but employees who exercise a large number of ISOs should consult a tax or financial advisor beforehand so that they can properly anticipate the tax consequences of their transactions. This article only covers the highlights of how these options work and the ways they can be used. For more information on incentive stock options, consult your HR representative or financial advisor.

An introduction to incentive stock options By Mark P. Key Characteristics of ISOs Incentive stock options are similar to non-statutory options in terms of form and structure.

Taxation of ISOs ISOs are eligible to receive more favorable tax treatment than any other type of employee stock purchase plan. There are two types of dispositions for ISOs: A sale of ISO stock made at least two years after the grant date and one year after the options were exercised. Both conditions must be met in order for the sale of stock to be classified in this manner.

To encourage employees to stick around and help the company grow, options typically carry a four to five year vesting period, but each company sets its own parameters. Advantages Disadvantages Allows a company to share ownership with the employees.

Used to align the interests of the employees with those of the company. In a down market, because they quickly become valueless Dilution of ownership Overstatement of operating income Nonqualified Stock Options Grants the option to buy stock at a fixed price for a fixed exercise period; gains from grant to exercise taxed at income-tax rates Advantages Disadvantages Aligns executive and shareholder interests.

Company receives tax deduction. No charge to earnings. Dilutes EPS Executive investment is required May incent short-term stock-price manipulation Restricted Stock Outright grant of shares to executives with restrictions to sale, transfer, or pledging; shares forfeited if executive terminates employment; value of shares as restrictions lapse taxed as ordinary income Advantages Disadvantages Aligns executive and shareholder interests. No executive investment required. If stock appreciates after grant, company's tax deduction exceeds fixed charge to earnings.

Immediate dilution of EPS for total shares granted. Fair-market value charged to earnings over restriction period. Company receives tax deduction at payout. Charge to earnings, marked to market. Difficulty in setting performance targets. When do Stock options work best? Appropriate for small companies where future growth is expected. For publicly owned companies who want to offer some degree of company ownership to employees.

What are important considerations when implementing Stock Options? How much stock a company be willing to sell. Who will receive the options.

Tax Treatment of ISOs

There are non-qualified options and incentive stock options (ISOs), both having specific tax triggers. Options can expire worthless. Imagine the thrill of a grant followed by the agony of a stock flop. Rather than acting as an employee incentive, options issued for a stumbling stock can muck-up morale. Incentive stock options are a form of compensation to employees in the form of stock rather than cash. With an incentive stock option (ISO), the employer grants to the employee an option to purchase stock in the employer's corporation, or parent or subsidiary corporations, at a predetermined price, called the exercise price or strike price. Stock can be purchased at the strike price as soon as the option vests . Incentive stock options (ISOs) are stock option plans usually available to executives & upper management. Learn about how they work and pros & cons here.