Incentive stock options (ISOs) are a type of employee stock option that can be offered to employees as a form of compensation. They are a popular choice for startups and other companies looking to attract and retain top talent, as they offer tax benefits to both the company and the employee. However, there are also several important considerations for both employees and companies to be aware of when it comes to ISOs. In this blog post, we'll take a closer look at ISOs from the perspective of a financial advisor, including how they work, the tax implications, and some of the pros and cons to be aware of.
How do incentive stock options work?
ISOs are a type of stock option that allows employees to purchase company stock at a discounted price, known as the "grant" or "exercise" price. The discount is typically equal to the difference between the market price of the stock at the time the option is granted and the exercise price.
For example, let's say a company grants an employee an ISO with an exercise price (known as the strike price) of $50 per share, and the market price of the stock rises to $100 per share subsequently. If the employee decides to exercise their option and purchase the stock, they will be able to buy it for $50 per share, despite the market price being $100 per share. This means the employee has effectively received a discount on the stock, which can be a significant benefit as long as the stock price increases over time.
There are several important rules and restrictions to be aware of when it comes to ISOs. For one, the employee must hold onto the stock for a certain period of time before they can sell it, known as the "holding period." The holding period for ISOs is typically one year from the date of exercise and two years from the date of grant. If the employee sells the stock before the holding period has been met, they may be subject to ordinary income tax on the difference between the exercise price and the sale price.
The tax implications of incentive stock options
One of the main benefits of ISOs is the favorable tax treatment they offer to both the company and the employee. From the company's perspective, there is no immediate tax deduction when an ISO is granted. However, if the employee holds onto the stock for the required holding period and sells it at a profit, the company can claim a tax deduction equal to the difference between the sale price and the exercise price. This can be a significant benefit for the company, as it allows them to offset some of their profits with the tax deduction.
From the employee's perspective, there are two key tax benefits to be aware of when it comes to ISOs. First, there is no tax due at the time the option is exercised (although AMT may apply depending on size). This means the employee can exercise their option and purchase the stock without having to pay any tax on the discount they receive. Second, if the employee holds onto the stock for the required holding period and sells it at a profit, the difference between the exercise price and the sale price is taxed as a long-term capital gain, rather than as ordinary income. This can result in a significantly lower tax rate for the employee, as long-term capital gains are typically taxed at a lower rate
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