One of the major benefits that many employers offer to their workers is the ability to buy company stock with some sort of tax advantage or built-in discount. There are several types of stock purchase plans that contain these features, such as nonqualified stock option plans. These plans are usually offered to all employees at a company, from top executives down to the custodial staff.

However, there is another type of stock option, known as an incentive stock option, which is usually only offered to key employees and top-tier management. These options are also commonly known as statutory or qualified options, and they can receive preferential tax treatment in many cases.

Key Characteristics of ISOs
Incentive stock options are similar to nonstatutory options in terms of form and structure.

Schedule
ISOs are issued on a beginning date, known as the grant date, and then the employee exercises his or her right to buy the options on the exercise date. Once the options are exercised, the employee has the freedom to either sell the stock immediately or wait for a period of time before doing so. Unlike non-statutory options, the offering period for incentive stock options is always 10 years, after which time the options expire.

Vesting
ISOs usually contain a vesting schedule that must be satisfied before the employee can exercise the options. The standard three-year cliff schedule is used in some cases, where the employee becomes fully vested in all of the options issued to him or her at that time. Other employers use the graded vesting schedule that allows employees to become invested in one-fifth of the options granted each year, starting in the second year from grant. The employee is then fully vested in all of the options in the sixth year from grant.

Exercise Method
Incentive stock options also resemble non-statutory options in that they can be exercised in several different ways. The employee can pay cash up front to exercise them, or they can be exercised in a cashless transaction or by using a stock swap.

Bargain Element
ISOs can usually be exercised at a price below the current market price and thus provide an immediate profit for the employee.

Clawback Provisions
These are conditions that allow the employer to recall the options, such as if the employee leaves the company for a reason other than death, disability or retirement, or if the company itself becomes financially unable to meet its obligations with the options.

Discrimination
Whereas most other types of employee stock purchase plans must be offered to all employees of a company who meet certain minimal requirements, ISOs are usually only offered to executives and/or key employees of a company. ISOs can be informally likened to nonqualified retirement plans, which are also typically geared for those at the top of the corporate structure, as opposed to qualified plans, which must be offered to all employees.

Taxation of ISOs
ISOs are eligible to receive more favorable tax treatment than any other type of employee stock purchase plan. This treatment is what sets these options apart from most other forms of share-based compensation. However, the employee must meet certain obligations in order to receive the tax benefit. There are two types of dispositions for ISOs:

  • Qualifying Disposition - A sale of ISO stock made at least two years after the grant date and one year after the options were exercised. Both conditions must be met in order for the sale of stock to be classified in this manner.
  • Disqualifying Disposition - A sale of ISO stock that does not meet the prescribed holding period requirements.

Just as with non-statutory options, there are no tax consequences at either grant or vesting. However, the tax rules for their exercise differ markedly from non-statutory options. An employee who exercises a non-statutory option must report the bargain element of the transaction as earned income that is subject to withholding tax. ISO holders will report nothing at this point; no tax reporting of any kind is made until the stock is sold. If the stock sale is a qualifying transaction, then the employee will only report a short or long-term capital gain on the sale. If the sale is a disqualifying disposition, then the employee will have to report any bargain element from the exercise as earned income.

Example
Steve receives 1,000 non-statutory stock options and 2,000 incentive stock options from his company. The exercise price for both is $25. He exercises all of both types of options about 13 months later, when the stock is trading at $40 a share, and then sells 1,000 shares of stock from his incentive options six months after that, for $45 a share. Eight months later, he sells the rest of the stock at $55 a share.

The first sale of incentive stock is a disqualifying disposition, which means that Steve will have to report the bargain element of $15,000 ($40 actual share price - $25 exercise price = $15 x 1,000 shares) as earned income. He will have to do the same with the bargain element from his non-statutory exercise, so he will have $30,000 of additional W-2 income to report in the year of exercise. But he will only report a long-term capital gain of $30,000 ($55 sale price - $25 exercise price x 1,000 shares) for his qualifying ISO disposition.

It should be noted that employers are not required to withhold any tax from ISO exercises, so those who intend to make a disqualifying disposition should take care to set aside funds to pay for federal, state and local taxes, as well as Social Security, Medicare and FUTA.

Reporting and AMT
Although qualifying ISO dispositions can be reported as long-term capital gains on the 1040, the bargain element at exercise is also a preference item for the Alternative Minimum Tax. This tax is assessed to filers who have large amounts of certain types of income, such as ISO bargain elements or municipal bond interest, and is designed to ensure that the taxpayer pays at least a minimal amount of tax on income that would otherwise be tax-free. This can be calculated on IRS Form 6251, but employees who exercise a large number of ISOs should consult a tax or financial advisor beforehand so that they can properly anticipate the tax consequences of their transactions. The proceeds from sale of ISO stock must be reported on IRS form 3921 and then carried over to Schedule D.

The Bottom Line
Incentive stock options can provide substantial income to its holders, but the tax rules for their exercise and sale can be very complex in some cases. This article only covers the highlights of how these options work and the ways they can be used. For more information on incentive stock options, consult your HR representative or financial advisor.

Related Articles
  1. Home & Auto

    Understanding Rent-to-Own Contracts

    They can work for you or against you. Here's how to negotiate a fair one.
  2. Home & Auto

    Avoiding the 5 Most Common Rent-to-Own Mistakes

    Pitfalls that a prospective tenant-buyer could encounter on the road to purchase – and how not to stumble into them.
  3. Home & Auto

    Renting vs. Owning: Which is Better for You?

    Despite the conventional wisdom, renting might make more financial sense than you think.
  4. Personal Finance

    How To Get That Entry-Level Financial Analyst Job

    Landing a job as a financial analyst takes study, strategy and a lot of hard work. Here's how to hone your competitive edge.
  5. Investing Basics

    Explaining Options Contracts

    Options contracts grant the owner the right to buy or sell shares of a security in the future at a given price.
  6. Home & Auto

    When Are Rent-to-Own Homes a Good Idea?

    Lease now and pay later can work – for a select few.
  7. Economics

    Explaining the Balanced Scorecard

    A balanced scorecard is a metric that measures a business’ performance.
  8. Investing News

    Employee Or Contractor? An On-Demand Economy Problem

    Several on-demand economy startups classify, or classified, their workers as contractors rather than employees. It is an unconventional approach to hiring and has been a hit with venture capitalists ...
  9. Home & Auto

    When Getting a Rent-to-Own Car Makes Sense

    If your credit is bad, rent-to-own may be a better way to purchase a car than taking out a subprime loan – or it may not be. Get out your calculator.
  10. Investing Basics

    What is a Public Company?

    A public company has sold stock to the public through an initial public offering (IPO) and that stock is currently traded on a public stock exchange.
RELATED TERMS
  1. Record Date

    The cut-off date established by a company in order to determine ...
  2. Corporate Social Responsibility

    Corporate initiative to assess and take responsibility for the ...
  3. Corporate Culture

    The beliefs and behaviors that determine how a company's employees ...
  4. Derivative

    A security with a price that is dependent upon or derived from ...
  5. Security

    A financial instrument that represents an ownership position ...
  6. Series 6

    A securities license entitling the holder to register as a limited ...
RELATED FAQS
  1. How does a forward contract differ from a call option?

    Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>
  2. What protections are in place for a whistleblower?

    Whistleblowers can play a critical role in ensuring the compliance, safety, honesty and legal fairness of governments and ... Read Full Answer >>
  3. Does my employer's matching contribution count towards the maximum I can contribute ...

    Contributions to 401(k) plans come from employee salary deferral and employer match dollars. According to the IRS, employees ... Read Full Answer >>
  4. What are the main risks associated with trading derivatives?

    The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>
  5. How can an investor profit from a fall in the utilities sector?

    The utilities sector exhibits a high degree of stability compared to the broader market. This makes it best-suited for buy-and-hold ... Read Full Answer >>
  6. What is the difference between derivatives and options?

    Options are one category of derivatives. Other types of derivatives include futures contracts, swaps and forward contracts. ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!