What is an 'Incentive Stock Option (ISO)'

An incentive stock option (ISO) is a type of employee stock option with a tax benefit that, when exercised, it isn't necessary to pay ordinary income tax. Instead, the options are taxed at a capital gains rate.

BREAKING DOWN 'Incentive Stock Option (ISO)'

Incentive stock options are typically offered as encouragement for employees to remain long-term with a company and contribute to its growth and further development. The options can serve as a form of compensation to augment current salaries, or as a way to reward employees in lieu of a traditional salary raise. Such stock options, like other benefits, could be used as a way to attract new hires, especially if the company cannot currently afford to pay competitive base salaries.

Although ISOs have more favorable tax treatment than non-qualified stock options (NSOs), they also require the holder to take on more risk by having to hold onto the stock for a longer period of time in order to receive the better tax treatment.

Also, numerous requirements must be met in order to qualify as an ISO.

How Incentive Stock Options Are Used

Incentive stock options typically are priced at the market value of the shares when they are granted by the company, known as the grant date. However, there is often also a period of time the employee must wait for the options to vest before they may exercise these options to acquire shares at that the strike price. The expectation is that the shares will increase in market value by the time they have vested, allowing the employee to buy the stock at a discount and potentially sell some or all of those shares at a premium.

If an incentive stock option is exercised, and the shares are sold, the taxes paid are typically based on the difference between the price when the shares were granted and the fair market value at the time they are exercised. That tax is also deferred until such time the stocks are sold.

The tax rate will be variable, stemming from the period of time the shares were owned. For instance, if shares from incentive stock options were sold two years after they were granted, and then one year after they were exercised, the gains will fall under long-term capital gains tax treatment. For shares sold earlier than that, the gains may be taxed as ordinary income. Gains from incentive stock options could also be subject to alternative minimum tax.

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