Incentive stock options (ISOs) are a type of employee stock options that can provide tax benefits to both the employer and employee. ISOs are often used as part of a compensation package to assist with employee retention. ISOs are also used to compensate certain highly valued employees.
Let’s take a closer look at how ISOs work, their pros and cons, and potential tax implications.
How do incentive stock options work?
ISOs are typically awarded to employees as part of their compensation package, allowing them to purchase company stock at a predetermined price, known as the exercise price or exercise price. The exercise price is typically set at or above the current market price of the stock at the time of grant, with the idea that employees may benefit from any future increase in the stock price.
ISOs may have certain limitations and restrictions. For example, there may be a limit on the number of ISOs that can be awarded to an employee, or there may be specific eligibility criteria, such as a minimum period of service or a maximum ownership stake in the company.
In addition, most employee stock options include a vesting period. This is the period of time you must be employed (or other stipulation) before you can exercise your options. Options often also have an expiration date, usually ten years from the time they are granted. The general rule of thumb is to exercise your options (i.e. buy the company’s underlying stock) when the current market price is higher than your options.
To qualify for favorable tax treatment, ISOs must meet certain requirements. The employee must hold the shares for a specified period, usually a minimum of one year from the date of exercise and two years from the date of grant. If this is met, any subsequent gain from the sale of the stock may qualify for long-term capital gains tax rates, which are often lower than ordinary income tax rates.
What Happens When You Exercise Incentive Stock Options?
By exercising your options, you purchase the underlying stock at a predetermined strike price. Upon exercise, you officially become the owner of the shares. When you exercise the ISOs, you may have to pay taxes on the so-called “bargaining element,” which is the difference between the strike price and the market price of the stock.
Keep in mind that most ISOs have a vesting period, meaning you can get the ISOs on a certain date, but you are not eligible to exercise the options until you vest, which in some cases takes years .
What are the disadvantages of incentive stock options?
While ISOs offer potential benefits, there are several drawbacks. For starters, ISOs can complicate your taxes. In some cases, exercising your options may trigger the alternative minimum tax (AMT), and generally you will likely need to consult a tax professional if you want to know what your liability will be when buying or selling the underlying shares.
ISOs also tend to be more valuable in the long term than in the short term, because to receive favorable tax treatment you typically have to hold the shares for one or more years. That means if you need quick access to cash, you’ll probably want to look elsewhere. In addition to holding periods, most ISOs are also subject to a vesting schedule.
Another potential drawback is that employers can only grant ISOs for a maximum of $100,000 (fair market value of the shares) per employee. If the share exceeds that amount, the ISOs are treated as non-statutory stock options (NSO), which are less favorable from a tax perspective. For highly paid employees where ISOs make up a large part of the compensation package, this can become a problem.
Finally, ISOs can be affected by market volatility and changes in the company’s stock price. If the stock value declines after the options are granted or during the holding period, the employee may face a situation where the options are “underwater,” meaning the exercise price is higher than the current stock price.
What is the difference between a stock option and an incentive stock option?
Generally, there are two types of stock options: employee or incentive stock options and non-statutory options (NSOs), also called non-qualified stock options. The main difference between the two is the way they are taxed, with ISOs generally being more beneficial. With NSOs, you are taxed at your regular income tax rate for the price benefit you got when you exercised the option. With ISOs, on the other hand, you may be able to qualify for the generally more favorable long-term price gains when you sell (as long as you meet the minimum holding period). However, ISOs have alternative minimum tax implications.
In short
Incentive stock options can be a valuable part of a compensation package, but you will need to carefully weigh the pros and cons before participating in an ISO program. Market volatility, the potential alternative minimum tax liability and longer holding periods for favorable tax treatment are all factors to consider. As with any investment or financial decision, seeking professional advice and conducting thorough research will help you make informed choices that meet your financial goals and risk tolerance.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
