What Is an Incentive Stock Option (ISO)?

An incentive stock option (ISO) is a company benefit that gives an employee the right to buy stock shares at a discounted price with the added allure of a tax break on the profit. The profit on incentive stock options is taxed at the capital gains rate, not the higher rate for ordinary income.

Non-qualified stock options (NSOs) are taxed as ordinary income.

Generally, ISO stock is awarded only to top management and highly-valued employees. ISOs also are called statutory or qualified stock options.

Understanding Incentive Stock Options (ISOs)

Stock options are offered by some companies to encourage employees to remain long-term with a company and contribute to its growth and development and to the rise in its stock price that results.

Key Takeaways

  • Stock options give an employee the right to buy a set number of shares at a set price after a future date.
  • The profits on incentive stock options are taxable at the capital gains rate rather than the higher income tax rate.
  • However, incentive stock options require a vesting period of at least two years and a holding period of more than one year before they can be sold.

Options are usually issued by publicly-traded companies or private companies planning to go public at a future date.

Options can serve as a form of compensation that augments salaries, or as a reward in lieu of a traditional salary raise. Stock options, like other benefits, can be used as a way to attract talent, especially if the company cannot currently afford to pay competitive base salaries.

The Lingo of Options

Options are issued, or "granted," at a price set by the company, called the "strike price." This may be approximately the price at which the shares are valued at that time. Options typically have a vesting period before they can be used, also set by the company.

When the vesting period expires, the employee can purchase the shares at the strike price, or "exercise the option." Then, the employee can sell the stock for its current value, pocketing the difference between the strike price and sale price as profit.

Incentive stock options must be held for more than one year from the date of exercise and two years from the time of the grant.

Of course, there's no guarantee that the stock price will be higher than the strike price at the time the options vest. If it's lower, the employee may hold onto the options until just before the expiration date in hopes that the price will rise. Incentive stock options usually expire after 10 years.

The Tax Deal for ISOs

Incentive stock options have more favorable tax treatment than non-qualified stock options in part because they require the holder to hold the stock for a longer time period.

This is true of regular stock shares as well. Stock shares must be held for more than one year for the profit on their sale to qualify as capital gains rather than ordinary income.

In the case of incentive stock options, the shares must be held for more than one year from the date of exercise and two years from the time of the grant. Both conditions must be met for the profits to count as capital gains rather than earned income.

Say a company grants 100 shares of incentive stock options to an employee on December 1, 2019. The employee may exercise the option, or buy the 100 shares, after December 1, 2021. The employee can sell the options at any time after one more year has passed to be eligible to treat the profit as capital gains.

The taxable profit is the difference between the strike price and the price at the time of sale.

The Tax Rates

As of 2019, the capital gains tax rates are 0%, 15%, or 20%, depending on the income of the individual filing.

The income tax rates for individual filers ranges from 12% to 32% depending on income.

ISOs Vs. NSOs

The profits on the sale of non-qualified stock options may be taxed as ordinary income or as some combination of ordinary income and capital gains, depending on how soon they are sold after the options are exercised.

In addition, some of the value of NSOs may be subject to earned income withholding tax as soon as they are exercised. No reporting is necessary for ISOs until the profit is realized.

For the employee, the downside of the ISO is the greater risk created by the waiting period before the options can be sold.

In addition, there is some risk of making a big enough profit from the sale of ISOs to trigger the federal alternative minimum tax. That usually applies only to people with very high incomes and very substantial options awards.