by Mark Cussen, CFP

Most employee stock programs are designed to benefit either rank-and-file employees or all types of employees at a company. However, there is one type of stock option plan that is usually only available to executives and upper management.

Incentive stock options (ISOs), also known as qualified or statutory stock options, resemble their non-qualified cousins in many respects. However, they are the only type of option that allows the participant to report all profit between the exercise and sale price as capital gains, provided certain conditions are met. In return for this privilege, incentive stock options must adhere to several rules that do not apply to other types of plans.

While ISOs are also referred to as qualified stock options, they should not be confused with qualified retirement plans that are governed by ERISA regulations.

What Are Incentive Stock Options (ISOs)?

Incentive stock options are much like non-qualified stock options in structure and design, except for their tax treatment. The employer still grants an employee the option (the right, but not the obligation) to purchase a specific number of shares of company stock within a prescribed period of time at a predetermined price (in most cases, the price the stock closed at on the grant date). The employee can then exercise the options at any time during the offering period by purchasing the stock at the exercise price. He or she can either sell the stock immediately and reap a quick profit, or wait and sell the shares later.

The actual exercise of the stock can take place in a few different ways, depending upon the wishes of the employer and the financial circumstances of the employee:

  • Cash Exercise. This is the most basic form of exercise, but the hardest for the employee, who has to pony up a sufficient amount of cash to buy the stock at the exercise price so that it can be sold. Of course, he or she will get this amount back from the sale, in addition to the spread (the difference between the market and exercise prices), when the stock is sold. The amount received is reduced by the amount of the commission charges for the purchase and sale transactions.
  • Cashless Exercise. This is the most widely used method of exercising options because it does not require employees to pay out-of-pocket to exercise the purchase transaction. This is usually done through a local brokerage firm chosen by the employer to facilitate the exercise for all its employees. The brokerage firm loans the employee the money to purchase the stock at the exercise price and then immediately sell it in the open market on the same day. The employee then repays the firm the amount of the loan plus all commissions, interest, and other fees, plus enough to cover withholding tax. The employee keeps the remainder as profit.
  • Stock Swap Exercise. This is an arrangement where an employee gives the brokerage firm shares of company stock that he or she already owns to cover the purchase.

Key Terms and Dates

  • Grant Date. This is the calendar day on which an employer grants an employee the option to buy a set number of shares at the exercise price within the offering period.
  • Offering Period. This is the period of time during which employees can exercise the options that they are granted. This period always begins on the grant date and ends on the expiration date. The offering period for ISOs is always 10 years.
  • Exercise Date. The exercise date is the calendar day on which an employee exercises the options; that is the right to buy the stock. Therefore, a purchase transaction always takes place on this date. A taxable event only occurs on this date for ISOs if the spread between the exercise price and the market price becomes a preference item for the Alternative Minimum Tax. Otherwise, the employee owes no tax on this date.
  • Exercise Price. This is the preset price at which the employer lets the employee buy stock in the plan. This price may be either the price the stock closed at on the day of the grant, or determined by a specific formula used by the employer.
  • Sale Date. This is, of course, the calendar day the stock is sold, and is the second date on which a taxable event occurs for holders of NQSOs. There can be several sale dates to go with a single exercise.
  • Clawback Provision. This type of provision is simply a list of conditions that could allow the employer to take back the options that it issued. This provision is usually included to protect the employer if it becomes financially unable to meet its obligations to the options.
  • Expiration Date. This is the calendar day on which the offering period expires.
  • Bargain Element. This is the difference between the exercise price of the option and the market price at which it is exercised.

Vesting Schedule

Most ISO plans contain a vesting schedule of some sort that must be satisfied before options can be exercised. It may only specify that an employee work at the company for a certain amount of time after the grant date, or it may list certain accomplishments, such as reaching a specific sales or production-related quota that must be met as well. Some plans also contain an accelerated vesting schedule that allows the employee to exercise the options immediately if the performance goals are met before the time element of the schedule is complete.

The time component of the vesting schedule can be structured in one of two ways:

  • Cliff Vesting. With cliff vesting, the employee becomes immediately vested in all of the options. This can happen within three to five years of the grant date.
  • Graded Vesting. This is a plan under which an equal portion of the options granted are available to be exercised each year. Typically, this starts in year two and continues through year six, with 20% of the options vesting each year.

Tax Treatment of ISOs

The taxation of ISOs is what sets them apart from not only their non-qualified cousins, but also all other types of company stock plans. ISOs stand alone as the only type of employee stock plan that allows participants to receive capital gains treatment on the entire amount between the exercise price and the sale price of the stock. Most other types of plans require that employees report the bargain element that they receive at exercise as W-2 income, but not ISO participants.

Qualifying Dispositions

In order to qualify for capital gains treatment, the shares received from ISOs must be held for at least one year from the date of exercise, and two years from the date of grant. If these requirements are met, then the sale is considered to be a qualifying disposition.

For example, Henry is awarded 1,000 ISOs in September of 2010 by his employer at an exercise price of $15. He exercises the options 14 months later in November of 2011 when the stock price is $30, and sells them 13 months after that in December of 2012 for $40. Because he held the shares for more than a year after exercise and for two years after the grant date, he reports the entire gain of $25 per share ($15 per share profit from exercise plus $10 per share profit from sale) as a long-term capital gain of $25,000 ($25 gain multiplied by 1,000 shares). If Henry were to sell the stock for a price below the exercise price, then he would, of course, declare a capital loss.

Disqualifying Dispositions

If the employee does not hold the stock for the required holding periods before selling it, then the sale becomes a disqualifying disposition. The tax rules pertaining to this type of transaction are a bit more complicated: Employees who make disqualifying dispositions must typically pay withholding tax on the bargain element of the sale, as well as capital gains tax on any profit realized from the sale of the stock.

Dispositions that are made under either of the following two conditions are considered to be disqualifying:

  1. Within two years of the grant date
  2. Within one year of exercise

The smaller of the following two amounts must be counted as W-2 income for disqualifying dispositions:

  1. The bargain element of the transactions on the date of exercise (the price difference between the exercise price and the market price of the stock on the date of exercise)
  2. The difference between the price from the sale and the exercise price

As with qualifying dispositions, there are no reportable tax consequences for disqualifying dispositions until the stock is sold, regardless of when it was exercised. Once it has been determined which of the above two amounts are smaller, participants who sell their stock in a disqualifying disposition have this amount taxed as W-2 income. Employees who sell their stock in a disqualifying disposition should take note that their employer is under no obligation to withhold any of the tax that they owe on the bargain element of the transaction, such as federal, state, and local tax, as well as Social Security and Medicare. Therefore, they need to set aside an appropriate amount of cash to cover this amount when they file their returns – or else be prepared to receive a proportionately smaller refund.

Compare how this works with the previous example, assuming the same grant and exercise dates: Henry is issued 1,000 ISOs at $15 in September of 2010. He again exercises them 14 months later in November of 2011 when the market price is $30, but this time sells them only three months after that (in February of 2012) at $40. This is a disqualifying disposition because the entire holding period was only 17 months long. He must report earned income of $15,000 from his exercise, as well as a $10,000 short-term gain.

If Henry had sold the stock for $25 a share, then he would only have to report $10,000 of earned income, and he would report no capital gain or loss. If he sold the stock for less than the exercise price, then he would only have a capital loss (the negative difference between the sale and exercise prices) and no earned income.

AMT Considerations

There is another key factor that further complicates the taxation of ISOs. Taxpayers who receive large amounts of income from certain sources, such as tax-free municipal bond income or state income tax refunds, may end up having to pay something known as alternative minimum tax. This tax was created by the IRS to catch taxpayers who might otherwise avoid taxation through the use of certain strategies, such as moving all of their money to municipal bonds in order to receive only tax-free income.

The formula that determines whether a taxpayer owes AMT is an independent calculation that counts certain items of income that would not be taxable on a regular 1040 as income. It also disallows some deductions that can normally be taken as well. One of these is the bargain element from exercise in a qualifying ISO disposition, which is considered a “preference item” of income for AMT. This means that this income, which is otherwise taxed as a long-term capital gain, is considered ordinary income for AMT purposes. Participants whose ISO exercises and sales land them in AMT territory can find themselves with a significantly higher tax bill than they would otherwise.

Employees can calculate whether they owe AMT by completing IRS Form 6251, and must report the gains and losses from the sale of their ISO shares on Form 3921, which is then carried to Schedule D. However, the rules and formulas used for AMT calculations are very complex, and any employee who is granted ISOs should immediately consult a qualified tax professional for advice on this matter. In some cases, it may be possible to accurately estimate the number of ISOs that can be exercised or sold without triggering this tax.

Advantages of ISOs

The benefits of ISOs are much the same as for their non-qualified counterparts:

  1. Additional Income. Employees who receive ISOs can increase their total compensation beyond what they actually earn in salary.
  2. Tax Deferral. Employees can defer taxation on their ISOs until after they sell the stock, although they might have AMT issues.
  3. Capital Gains Treatment. All of the income from ISOs can be taxed as a long-term capital gain, provided the holding periods are met and the exercise does not trigger AMT.
  4. Enhanced Employee Motivation and Retention. Employees who receive ISOs are more likely to stay with the company and work hard.

Disadvantages of ISOs

  1. Lack of Diversification. Employees who receive ISOs may end up becoming too heavily invested in company stock compared with the rest of their investment portfolios.
  2. Loss of Capital Gains Taxation. Employees who sell their stock in a disqualifying distribution can only report the difference between the exercise and sale prices as a capital gain; the remainder is classified as earned income.
  3. Alternative Minimum Tax. The amount of the bargain element at exercise can become a preference item for AMT in some cases, which means that the employee may pay much more tax on the exercise.
  4. Higher Taxes. The sale of ISOs can land the participant in a higher tax bracket for the year if he or she does not plan ahead, although in some cases it is unavoidable.
  5. Limits on Issuance. Employers cannot issue more than $100,000 worth of ISOs (valued as of the grant date) to an employee in a calendar year.
  6. No Withholding. Employers are not required to withhold any type of tax from ISO exercises, so employees must keep track of and report this element of the transaction themselves.
  7. No Tax Deductions. Employers cannot deduct the bargain element of an ISO exercise as compensation paid unless the stock is sold in a disqualifying disposition.

Final Word

Incentive stock options can provide an alternative source of income for employees who are awarded them, even if the company’s stock is not publicly traded. If a closely held business is bought out by a publicly-traded firm, then the options may become immediately vested and thus convertible into quick cash.

However, the tax rules that govern them can be quite complicated in some instances, especially when large numbers of options are exercised. Employees who face the possibility of realizing substantial income from either the exercise or sale of this class of option should be certain to schedule a prior consultation with a tax or financial expert who has experience in working with these instruments.

Mark Cussen, CFP, CMFC has 17 years of experience in the financial industry and has worked as a stock broker, financial planner, income tax preparer, insurance agent and loan officer. He is now a full-time financial author when he is not on rotation doing financial planning for the military. He has written numerous articles for several financial websites such as Investopedia and Bankaholic, and is one of the featured authors for the Money and Personal Finance section of eHow. In his spare time, Mark enjoys surfing the net, cooking, movies and tv, church activities and playing ultimate frisbee with friends. He is also an avid KU basketball fan and model train enthusiast, and is now taking classes to learn how to trade stocks and derivatives effectively.

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