Incentive stock options

Incentive stock options is a money term you need to know. Bankrate explains.

What are incentive stock options?

Incentive stock options, also referred to as qualified stock options, are stock options that can only be granted to employees and receive favorable tax treatment when exercised. Gains from incentive stock options are taxed at a long-term capital gains rate. Unlike non-qualified stock options, issuing companies cannot deduct the cost of incentive stock options as an operating expense.

Deeper definition

Stock options are granted by certain companies as a form of deferred compensation. They grant employees and certain other parties the right to purchase a given number of the company’s shares at a fixed price — called the grant price or the strike price — after a set amount of time has gone by. Holders generally exercise stock options when the market price has risen above the grant price, giving them a discount on the shares. They either hold the shares obtained in the exercise of the option, or sell them immediately for a profit.

Incentive stock options are governed by vesting schedules. Options vest over time, or when key company goals are met. Various graduated vesting schedules are used, with a portion of the options vesting every year an employee stays with a company. A three-year vesting schedule is very common. If an employee vests one-fifth of the options granted to her annually, she becomes fully vested after six years. Once vested, the employee can exercise options at the grant price at any time over the option term up to the expiration date.

Incentive stock options receive more favorable tax treatment than other stock options. If shares of stock gained from incentive stock options are sold two years after the grant date or one year after the exercise date, the profits are a qualifying disposition taxed at the short- or long-term capital gains rate. If the shares of stock are sold before these thresholds, the profits are taxed as ordinary earned income.

Incentive stock options may only be exercised if the market price is equal to the grant price. If the price is lower than the grant price, it would entail paying a premium for the shares. Non-qualified stock options may be sold at any market price, either higher or lower than the grant price.

While non-qualified stock options carry less favorable tax treatment for the holder than incentive stock options, they offer other benefits. Non-qualified stock options can be issued to anyone — employees, board members, advisors, vendors — whereas incentive stock options may only be issued to employees. There are strict limitations on the total market value of incentive stock options that can be exercised in one calendar year.

Incentive stock options example

Zeke is a new employee of Mobiledyne, a tech start-up firm, and is granted the right to buy 10,000 shares at $10 per share after three years of employment. The options vest at 33 percent annually over three years and have a term of 10 years. As the market value of Mobiledyne’s stock continues to rise, Zeke will still only pay $10 per share to exercise his options. The difference between the $10 grant price and the exercise price is the spread. If Mobiledyne’s stock goes to $25 after seven years, and Zeke exercises all his options, the spread will be $15 per share, paying $100,000 for stock carrying a market value of $250,000.

More From Bankrate

  • Current Student Loan Interest Rates

    __BYLINE__ __INSERT-DATE__ Student loans can be a useful way to fill financial gaps in paying for higher education expenses. However, borrowing money for school comes at a cost, particularly in the form [...]

    8 MIN READ Nov. 13, 2020
    Placeholder image
  • Shop Through Chase Guide

    If you’re a savvy rewards card member on the hunt for points, chances are you’ve learned to maximize your reward categories in order to wring every point you can from your purchases. But unfortunately, [...]

    6 MIN READ Oct. 21, 2020
    Placeholder image
  • 7/1 ARM rates

    Today’s 7/1 ARM Rates The table below brings together a comprehensive national survey of mortgage lenders to help you know what are the most competitive 30-year mortgage rates. This interest rate table [...]

    1 MIN READ Sep. 22, 2020
    Placeholder image
  • The Best New Hampshire Home Insurance Companies 2021

    Few states can match New Hampshire’s natural beauty and charming New England architecture. Whether you live in a traditional Victorian home or a modern dwelling, you need adequate home insurance coverage. [...]

    5 MIN READ Feb. 12, 2020
    Placeholder image
  • Are credit card rewards taxable?

    The IRS generally doesn’t consider credit card rewards to be taxable income, but there are some exceptions.

    3 MIN READ Jan. 23, 2020
    Placeholder image
  • TEMP Popular Cards for Foreign Travel from our Partners

    Advertiser Disclosure: The credit card offers that appear on the website are from companies from which this site receives compensation. This compensation may impact how and where products appear on this [...]

    8 MIN READ Nov. 8, 2018
    Placeholder image
  • Best Credit Cards for Limited or No Credit

    Advertiser Disclosure: The credit card offers that appear on the website are from companies from which this site receives compensation. This compensation may impact how and where products appear on this [...]

    9 MIN READ May. 18, 2018
    Placeholder image