Incentive stock options (ISOs), also referred to as qualified stock options, are a form of compensation as stock options rather than cash. With ISOs, an employer grants an employee the right, not obligation, to purchase a given number of shares of the company’s stock at a specific price within a specific time period. ISOs are typically offered to attract new employees and as incentive for employees to remain long-term with a company and be motivated to contribute to its success. ISOs are usually only offered to executives or key employees of a company and can offer a great opportunity for the employee to increase their income substantially and receive preferential tax treatment.

The expectation is that the shares will increase in market value by the time the employee is able to purchase the stock at a discount and potentially sell them at a higher price. There are specific rules, which are determined by the company, that need to be followed in order to receive the possible benefits of an ISO. Because of the potential financial gain, it is necessary to follow carefully the rules spelled out in the ISO agreement between the employer and employee.

The key aspects of ISOs are the following:

Grant Date & Grant Price:

The grant date is the date the stock options are granted to the employee by the company. The grant price is typically the price of the share on the grant date. The grant price is the price that the employee can buy the shares of stock.

Vesting Period:

There is often a period of time the employee must wait for the options to vest before he or she can exercise the option to buy shares. The following are the typical vesting time frames used:

Cliff Vesting: The employee becomes immediately vested in all of the options which usually would be within three to five years of the grant date.
Graded Vesting: An equal portion of the options granted are available to be exercised each year. Usually, this starts in year two and continues through year six, with 20% of the options vesting each year.

Exercise the Option:

To exercise the option is to purchase the stock once the vesting period is satisfied. Once the options are exercised, the employee can sell the stock immediately or wait. The offer period for ISOs is 10 years, so the options will expire if not exercised at this time.

There are typically three ways to exercise the option:

Cash exercise: The employee pays cash for the shares.

Cashless exercise: The employee simultaneously buys the stock and sells the shares needed to cover this cost.
Stock Swap Exercise: The employee gives the brokerage firm shares of company stock that he or she already owns to cover the purchase.

Tax Treatment of Exercising Incentive Stock Options

One of the most significant benefits of utilizing ISOs, is the tax benefit. With ISOs, you do not have to report income when you receive a stock option grant or when you exercise that option. You report the taxable income only when you sell the stock. ISOs are the only type of employee stock plan that allows employees to receive capital gains treatment on the amount gained between the exercise price and the sale price of the stock, which is called the “bargain element”. Most other plans require you to report the bargain element received at exercise as income. This is significant due to long-term capital gains being taxed at much lower rates than ordinary income.

The bargain element at exercise is also considered a preference item for the alternative minimum tax (AMT). AMT tax is assessed to those who have large amounts of certain types of income, including the ISO bargain element. The tax rules that govern ISOs can be complex. It is good practice to consult with a tax professional who has experience working with ISOs to help you understand the tax implications.

If you are fortunate enough to be offered ISOs, it can be well worth taking advantage of this opportunity and being aware of the possible tax implications can help you make good financial decisions.

Carol Chaudet

(Updated 10/3/2018)