What You Need to Know About Incentive Stock Options

An incentive stock option (ISO) plan allows employees the potential opportunity to purchase shares of their employer’s stock at a discounted price. ISOs offer many tax benefits, making them an attractive option for employees who wish to partake in the future growth of their employer’s stock.

One of the many benefits of ISOs is the deferral of income tax until they are exercised. Employees may generally defer the ISO discount (i.e., the difference between the exercise price of the ISO and the fair market value (FMV) of the stock at the time of exercise) until the stock is eventually sold.

Better yet, if the stock is held for more than one year past the exercise date and more than two years past the grant date, then the sale of the stock will be subject to preferential capital gain tax rates instead of ordinary income tax rates. This can result in significant tax savings for employees because the top tax rate for ordinary income is 37%, and the top tax rate for long-term capital gain is 20% (plus the 3.8% net investment income tax).

There are several conditions that must be met before an option can qualify as an ISO. First, an ISO can only be granted to an employee of a company and not to an outside consultant or investor. Additionally, the exercise price must be at least equal to the FMV of the stock at the time of grant. Failure to meet these and other conditions will result in the option being treated as a non-qualified stock option (NQSO), which is subject to ordinary income tax on exercise.

Another important consideration when exercising an ISO is the holding period for the stock after exercise. If the employee holds the stock for one year or less after exercise or two years or less after the grant date, the gain will be taxed as ordinary income subject to payroll taxes. This is known as a “disqualifying disposition” and is intended to prevent employees from receiving the tax benefits of ISOs without the associated risk of holding the stock for a longer period of time.

There are many benefits to implementing an ISO plan that go beyond the tax benefits. For example, an ISO can be used to attract and retain top talent. By offering the opportunity to invest in the company’s stock at a discounted price, ISOs provide employees with a sense of ownership, and the tax benefits encourage long-term ownership, motivating employees not only to stay with the company but also to work towards the company’s long-term success.

It is important to note that there are certain disadvantages to ISOs. For example, the exercise price is typically set at the FMV of the stock at the time of grant, which means that the employee may not benefit if the stock price does not rise significantly after the grant date. This is especially true in the current environment.

Additionally, the exercise of ISOs may trigger the alternative minimum tax (AMT). The AMT is a separate tax system designed to ensure that taxpayers with high income or certain types of income pay at least a minimum amount of tax. With ISOs, the discount is considered a “preference item” for AMT purposes. Because the holding period requirements favor long-term stock ownership after exercise of an ISO, the imposition of the AMT on exercise of an ISO forces an employee to pay tax before she wants to sell the stock to generate funds to pay the tax.

Another drawback to ISOs is the $100,000 annual limit on the exercise of ISOs. To the extent that the FMV of stock that becomes exercisable with respect to stock options within a calendar year exceeds $100,000, such excess is treated as a NQSO that is subject to tax on the exercise date.

Last, the issuance of ISOs is non-deductible for the employer, unlike NQSOs. Although ISOs are tax advantageous to employees, they are not as tax advantageous to the company granting them.

ISOs are an attractive option for employees who wish to invest in their employer’s stock, but it is important to understand the tax requirements that must be met for an option to qualify as an ISO, as well as the holding period requirements for the stock after an ISO is exercised. It is also important to weigh the benefits and burdens of ISOs before deciding to participate in an ISO plan. If you have questions about ISOs or other forms of stock options, please reach out to your Withum Advisor.