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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.
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.