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Incentive stock options (ISOs) are a type of employee stock option that can provide tax benefits for both the employer and the employee. ISOs are often used as a component of a compensation package to help 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 granted to employees as part of their compensation package, allowing them to purchase company stock at a predetermined price, known as the exercise price or strike price. The exercise price is usually set at or above the current market price of the stock at the time of grant, with the idea that employees can potentially benefit from any potential future stock price appreciation.
ISOs can have certain limitations and restrictions. For instance, there may be a limit on the number of ISOs that can be granted to an employee, or there may be specific eligibility criteria, such as a minimum period of employment or a maximum ownership stake in the company.
Additionally, most employee stock options come with a vesting period. This is the time period you must be employed (or other stipulation) before you can exercise your options. Options also often have an expiration date, typically 10 years from when they’re granted. The general rule of thumb is to exercise your options (i.e. buy the underlying company 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 stock for a specified period, generally at least one year from the date of exercise and two years from the date of grant. If these are 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?
Exercising your options means you purchase the underlying stock at a predetermined strike price. Upon exercising, you become the official owner of the shares. When you exercise the ISOs, you might have to pay taxes on what’s called the “bargain element,” which is the difference between the strike price and the market price of the stock.
Keep in mind most ISOs come with a vesting period, meaning you may be granted the ISOs on a certain date, but you won’t be eligible to exercise the options until you’re vested, which in some cases takes years.
What are the disadvantages of incentive stock options?
While ISOs offer potential benefits, there are several drawbacks. To start, ISOs can complicate your taxes. In some cases, exercising your options may trigger the alternative minimum tax (AMT), and in general, you’ll likely need to consult with a tax professional if you want to know your liability when buying or selling the underlying stock.
ISOs are also generally more valuable in the long term rather than the short term, since to receive favorable tax treatment you generally need to hold the stock for one or more years. That means if you need quick access to cash, you’d 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 up to $100,000 (fair market value of the stock) per employee. If the stock exceeds that amount, the ISOs are treated like nonstatutory stock options (NSO) which are less favorable tax-wise. For well-paid employees where ISOs are a large portion of the compensation package, this could become an issue.
Lastly, 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?
In general, there are two types of stock options: employee or incentive stock options and non-statutory options (NSOs), also known as non-qualified stock options. The major difference between the two is how each is taxed, with ISOs typically being more advantageous. With NSOs you’re taxed at the regular income tax rate for the price break you received when you exercised the option. ISOs, on the other hand, allow you to possibly qualify for the generally more favorable long-term capital gains rate when you sell (as long as you meet the minimum holding period). ISOs do, however, have alternate minimum tax implications.
Incentive stock options can be a valuable component of a compensation package, but you’ll want to carefully weigh the advantages and disadvantages 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 that should be considered. As with any investment or financial decision, seeking professional advice and conducting thorough research help you make informed choices that align with your financial goals and risk tolerance.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.