What Are Incentive Stock Options?

What Are ISOs (Incentive Stock Options)?

An incentive stock option (ISO) is a corporate benefit that enables workers to buy company stock at a discounted price and potentially save money on taxes. Profits from eligible ISOs are generally taxed at the capital gains rate rather than the higher ordinary-income rate, and ordinary income is taxed on nonqualified stock options (NSOs).

ISO stock is often exclusively given to senior management and highly valued staff. Statutory or qualified stock options are other names for ISOs.

Learning About Incentive Stock Options (ISOs)

Some firms give incentives or statutory stock options to motivate workers to stay with a company for a long time and contribute to its growth and development and the following increase in its stock price.

ISOs are often offered by publicly listed firms or private companies seeking to become public in the future. They need a plan document that specifies how many options will be provided to workers. Employees who get options must use them within ten years after obtaining them.

Options may be used as supplemental payor as an incentive in place of a standard salary increase.

Stock options, like other incentives, may be used to recruit talent, mainly if the firm is unable to provide a competitive base salary at the moment.

Incentive Stock Options (ISOs) Work

The "strike price" is the price at which the employer firm gives or "grants" stock options. This might be a rough estimate of the worth of the stock at the moment.

On the grant day, ISOs are granted, and on the exercise date, the employee exercises their right to purchase the options. When the employee's options are exercised, they have the choice to sell the shares right away or wait a certain amount of time. Unlike non-statutory options, ISOs always have a 10-year offering term, after which the options expire.

Employee stock options (ESOs) usually have a vesting schedule that must be followed before exercising the options. In other circumstances, the usual three-year cliff schedule is followed, in which the employee becomes fully vested in all options awarded at that time.

Other companies adopt a graded vesting schedule, which permits workers to invest in one-fifth of the options issued each year beginning the second year after the award. After receiving the grant, the employee is fully vested in all options in the sixth year.

Particular Considerations

When the vesting period ends, the employee may "exercise the option" and buy the shares at the strike price. The employee may then sell the shares for their current value and profit on the difference between the strike price and the selling price.

Of course, there's no assurance that the stock price when the options vest will be greater than the strike price. If the price is lower, the employee may keep the options until shortly before they expire, hoping that the price will climb. ISOs typically last for ten years.

An ISO issue may also include clawback provisions. These circumstances enable the employer to recall the options, such as if the employee quits the firm for reasons other than death, incapacity, or retirement, or if the company becomes financially unable to pay the options' responsibilities.

ISOs have a more favorable tax treatment than nonqualified stock options (NSOs) since they require the holder to retain the shares for a longer length of time. This is also true for average stock shares, and the profit on the selling of stock shares must be kept for more than one year to qualify as capital gains rather than ordinary income.

The shares must be retained for at least one year from the date of exercise and two years from the date of grant in the case of ISOs. Both requirements must be satisfied for for-profits to be classified as capital gains rather than earned income.

Consider the following scenario. On December 1, 2019, a corporation gave 100 shares of ISOs to an employee. After December 1, 2021, the employee may execute the option or purchase the 100 shares.

After one year, the employee may sell the options and claim the earnings as capital gains. The difference between the strike price and the price at the moment of selling is the taxable profit.

Rates of Taxation

Capital gains tax rates will be 0%, 15%, or 20% in 2021, depending on the person's income.

Meanwhile, individual filers' marginal income tax rates vary from 10% to 37%, depending on their income.

Nonqualified Stock Options vs. Incentive Stock Options (NSO).

The proceeds are taxed as ordinary income when a nonqualified stock option (NSO) is exercised.

Furthermore, when NSOs are exercised, part of their value may be subject to earned income withholding tax. In the case of ISOs, however, no reporting is required until the profit is realized.

ISOs are similar to non-statutory options in that they may be used in various ways. Employees may exercise their options by paying cash upfront or utilizing a cashless transaction or a stock exchange. Depending on how soon the options are exercised, earnings on the selling of NSOs may be taxed as ordinary income or a mix of regular income and capital gains.

The disadvantage of the ISO for the employee is the increased risk posed by the waiting time before the options may be sold. Furthermore, there is a chance that the selling of ISOs will result in a large enough profit to trigger the federal alternative minimum tax (AMT). This generally only applies to those with very high earnings and large option rewards.

Apart from taxes, ISOs include a discrimination component. ISOs are often exclusively provided to executives and significant workers of a firm. However, most other employee stock purchase programs must be offered to all employees who satisfy specific minimum standards. Nonqualified retirement plans, like ISOs, are often tailored to individuals at the top of the company hierarchy instead of qualified retirement plans, which must be given to all workers.

ISOs' Most Important Features

In terms of form and structure, incentive stock options are comparable to non-statutory options.

Schedule: ISOs are granted on a start date, known as the grant date, and the employee exercises their right to purchase the options on the exercise day. When the employee's options are exercised, they have the choice to sell the shares right away or wait a certain amount of time. Unlike non-statutory options, incentive stock options have a 10-year offering term, after which the options expire.

Vesting: Most ISOs include a vesting schedule that must be followed before the employee may exercise their options. In other circumstances, the usual three-year cliff schedule is followed, in which the employee becomes fully vested in all options awarded at that time. Different companies adopt a graded vesting schedule, which permits workers to invest in one-fifth of the options issued each year beginning the second year after the award. After receiving the grant, the employee is fully vested in all options in the sixth year.

Method of Exercise: Non-statutory stock options are similar to incentive stock options in that they may be exercised in various ways. Employees may exercise their options by paying cash upfront or utilizing a cashless transaction or a stock exchange.

ISOs may frequently be exercised at a lower price than the current market price, resulting in an instant benefit for the employee.

Clawback Provisions: These are circumstances that enable the employer to recall the options, such as if the employee quits the firm for reasons other than death, incapacity, or retirement, or if the company becomes financially unable to pay the options' responsibilities.

Discrimination: Unlike most other forms of employee stock purchase programs, ISOs are often exclusively available to executives and senior workers of a firm who fulfill specific minimum standards.

Nonqualified retirement plans, like ISOs, are constantly tailored to individuals at the top of the company hierarchy instead of qualified retirement plans, which must be given to all workers.

Taxation of ISOs

ISOs qualify for preferential tax treatment over other types of employee stock purchase plans, and this is what distinguishes these options from most other types of stock-based remuneration. However, in order to earn the tax advantage, the employee must fulfill specific requirements. There are two kinds of ISO dispositions:

A sale of ISO stock done at least two years after the grant date and one year after the options were exercised qualifies as a qualifying disposition. For a stock sale to be classed in this way, both requirements must be satisfied.

A sale of ISO shares that do not fulfill the required holding time is a disqualifying disposition.

There are no tax repercussions at either grant or vesting, just like non-statutory options. However, the tax laws governing their use vary significantly from those governing non-statutory alternatives. When an employee exercises a non-statutory option, the bargain portion of the transaction must be reported as earned income subject to withholding tax. At this time, ISO holders will not disclose anything; no tax reporting of any type will be done until the shares are sold. If the stock sale qualifies, the employee will only have to record a short-term or long-term capital gain on the transaction. If the deal is a disqualifying disposition, any bargain element from the exercise must be reported as earned income by the employee. 

Pat's firm gives him 1,000 non-statutory stock options and 2,000 incentive stock options. The cost of both exercises is $25. They execute all of the options about 13 months later, when the company is selling at $40 a share, and then sell 1,000 shares of stock from their incentive options for $45 a share six months later. They sell the remaining shares for $55 per share eight months later.

Pat will have to declare the bargain portion of $15,000 ($40 total share price - $25 exercise price = $15 x 1,000 shares) as earned income since the first sale of incentive stock is disqualifying disposal. They'll have to do the same with the bargain portion of their non-statutory exercise, resulting in an extra $30,000 in W-2 income to report in the exercise year. However, for their qualifying ISO disposal, they will only say a long-term capital gain of $30,000 ($55 selling price - $25 exercise price x 1,000 shares).

Employers are not obliged to withhold any taxes from ISO exercises, so individuals planning to make a disqualifying disposition should make sure they have enough money put aside to cover federal, state, and local taxes, Social Security, Medicare, and FUTA.

AMT and reporting

Although qualified ISO dispositions may be reported on the IRS form 1040 as long-term capital gains, the bargain factor upon exercise is a preference item for the alternative minimum tax. This tax is imposed on filers with a significant amount of specific forms of income, such as ISO deal components or municipal bond interest. It is intended to guarantee that the taxpayer pays at least a small amount of tax on income that would otherwise be tax-free. This may be estimated using IRS Form 6251. Still, workers who exercise a high number of ISOs should contact a tax or financial expert ahead of time to ensure that the tax implications of their transactions are correctly anticipated. The profits from the sale of ISO shares must be recorded on IRS Form 3921, then transferred to Schedule D.

Holding time risk is one of the ISO cautions to bear in mind. Waiting to meet the "qualifying disposition" conditions makes sense from a tax standpoint. However, the stock might decline during this period, rendering your stock option worthless.

Stock is concentrated. Diversification distributes your assets across numerous asset types to decrease risk and manage volatility. As a result, it's critical to make sure you're not unduly invested in your company's shares to reduce overall portfolio risk.

Payment of AMT Payment may be demanding if AMT is triggered. You can be trapped paying your alternative minimum tax bill before selling the stock, which means you won't be able to utilize the sale profits to pay your tax obligation. Consider exercising ISOs early in the calendar year to give yourself more time to save money and manage your AMT liabilities. You might potentially avoid AMT by selling the stock in the same year you exercised it. If the price of your company's shares falls after you've exercised your ISOs, it can make sense to sell them the same year. Although this would result in disqualifying disposal and the bargain portion being taxed as short-term capital gains, it might help you avoid AMT and minimize your tax burden.

Withholding of taxes. Your employer is not required to withhold taxes on your behalf since taxes are not owed until shares are sold using ISOs. It's critical to examine your tax burden and put aside the necessary monies in advance of selling your stock.

Departure from the company. If you leave your job but have vested ISOs, bear in mind that you usually have three months to exercise them to retain your ISO status, and your ISOs will become NSOs after this period.

ISO's cap is $100,000. The number of ISOs a company may provide to each employee in a calendar year is restricted. The options exceeding the limit are classified as NSOs if the stock's fair market value surpasses $100,000.

If you get ISOs as part of your remuneration, the goal is that the share price of your firm will rise much beyond the strike price over time. If this occurs, exercising your options would allow you to sell for a reasonable profit. However, using your ISOs necessitates dealing with complex tax conditions. Hiring professional tax and financial consultants that can assess your whole financial status might assist you in exercising your ISOs and selling your company's shares at the most advantageous moment.

How to Get Assistance with ISOs

ISOs and other kinds of equity compensation may help you create wealth over time, so be sure you know how to manage them properly. Working with a financial adviser may help you figure out when to use your alternatives and what tax ramifications they may have.

In conclusion

Holders of incentive stock options may earn a lot of money, but the tax requirements for exercising and selling them can be complicated in certain situations. This article touches on the most critical aspects of how these choices function and how they might be utilized. Consult your HR representative or financial adviser for further information on incentive stock options.