Incentive Stock Options (ISO): Definition and Meaning

What Are Incentive Stock Options (ISOs)?

An incentive stock option (ISO) is a corporate benefit that gives an employee the right to buy shares of company stock at a discounted price with the added benefit of possible tax breaks on the profit. The profit on qualified ISOs is usually 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.

Key Takeaways

  • Incentive stock options (ISOs) are popular measures of employee compensation, granting rights to company stock at a discounted price at a future date.
  • This type of employee stock purchase plan is intended to retain key employees or managers.
  • ISOs require a vesting period of at least two years and a holding period of more than one year before they can be sold.
  • ISOs often have more favorable tax treatment on profits than other types of employee stock purchase plans.

Understanding Incentive Stock Options (ISOs)

Incentive or statutory 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 subsequent rise in its stock price.

ISOs are usually issued by publicly-traded companies, or private companies planning to go public at a future date, and require a plan document that clearly outlines how many options are to be given to which employees. Those employees must exercise their options within 10 years of receiving them.

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.

How Incentive Stock Options (ISOs) Work

Stock options are issued, or "granted," at a price set by the employer company, called the "strike price." This may be approximately the price at which the shares are valued at that time.

ISOs are issued on a beginning date, known as the grant date, and then the employee exercises their 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 ISOs is always 10 years, after which time the options expire.

ISOs can often be exercised to purchase shares at a price below the current market price and, thus, provide an immediate profit for the employee.

Employee stock options (ESOs) typically have 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 them at that time.

Other employers use the graded vesting schedule, which allows employees to become invested in one-fifth of the options granted each year, starting in the second year from the grant. The employee is then fully vested in all of the options in the sixth year from the grant.

Special Considerations

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.

ISOs must be held for more than one year from the date of exercise and two years from the time of the grant to qualify for more favorable tax treatment.

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. ISOs usually expire after 10 years.

Clawback provisions may also exist in an ISO issue. 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.

Tax Treatment for Incentive Stock Options (ISOs)

ISOs have more favorable tax treatment than non-qualified stock options (NSOs) 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 ISOs, 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.

Let's look at an example. Say a company grants 100 shares of ISOs 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.

Tax Rates

As of 2021, the capital gains tax rates are 0%, 15%, or 20%, depending on the income of the individual filing. The marginal income tax rates for individual filers, meanwhile, range from 10% to 37%, depending on income.

Incentive Stock Options (ISOs) vs. Non-Qualified Stock Options (NSO)

A non-qualified stock option (NSO) is a type of ESO that is taxed as ordinary income when exercised. In addition, some of the value of NSOs may be subject to earned income withholding tax as soon as they are exercised. With ISOs, on the other hand, no reporting is necessary until the profit is realized.

ISOs resemble non-statutory options in that they can be exercised in several different ways. The employee can pay cash upfront to exercise them, or they can be exercised in a cashless transaction or by using a stock swap. The profits on the sale of NSOs 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.  

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 (AMT). That usually applies only to people with very high incomes and very substantial options awards.

Outside of taxation, ISOs feature an aspect of what is called 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 non-qualified retirement plans, which are also typically geared toward those at the top of the corporate structure, as opposed to qualified plans, which must be offered to all employees.

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