ISO Stock Options: Tax and Requirements

ISO stock options are corporate benefits that give an employee the right to buy company shares at a discounted rate with a more favorable tax treatment on the profit or income. In this article, we shall look at how ISO stock options work, their characteristics, tax treatment, how they are reported, examples, and their requirements.

ISO stock options are usually awarded as part of an employee’s hiring or promotion package. They are generally awarded only to top management and highly valued employees. The profit on incentive stock options is taxed at the capital gains rate rather than the higher rate for ordinary income as it is in the case of nonqualified stock options.

Such stock options are used to motivate and retain key employees. Since one has to hold on to ISO stock options for a period of time, the only way to capitalize on these benefits is to stay with the firm for a long period. The higher the share price of a company rises, the greater the reward from stock options. This encourages high productivity from key employees as they directly benefit from the company’s success.

ISO stock options are usually issued by publicly-traded companies or private companies that are planning to go public at a future date and require a plan document that clearly outlines the number of options that are to be given to which employees. Such employees must exercise their options within ten years of receiving them.

Options can serve as a form of compensation that increases salaries or as a reward in agreement with traditional salary rises. Stock options like other benefits can be used as a way to attract talent especially if the company is currently unable to afford to pay competitive base salaries.

ISO stock options
ISO stock options

See also: Early Exercise of Stock Options

How do incentive stock options work?

The day a company issues ISO stock options to an employee is known as the grant date. It is at this point that the ISO stock options are subject to a vesting schedule or waiting period until the employee gains ownership. Once the incentive stock options vest, the employee has the right, not the obligation, to purchase a certain number of company shares at the strike price which is the fixed exercise price indicated in the ISO grant.
The employee can choose whether or not to exercise the stock options until the ISO expiry date. Typically, the time frame before expiry is ten years.

Generally, if the strike price of your ISO stock options is less than the current market price of your company’s shares, you may consider exercising your options. It is this way that you could buy the stock at a lower strike price and in turn, sell these shares in the market to earn the bargain element which is the difference between your strike price and the market price.

If the strike price is greater than the current market price, it would not be reasonable to exercise your incentive stock options because the shares of the company would be cheaper on the stock market. If the strike price never goes below the market price, there is a possibility for your ISO stock options to expire worthlessly.

When exercising your ISO stock options, it is not always necessary to purchase the shares with cash, one could potentially opt for a stock swap depending on whether the employer offers it. Here, the company’s already owned shares will be exchanged to get more shares.

For example, you can purchase 1,000 company shares of stock at $20 per share with your vested ISO. Shares are trading for $40 in the market. In this case, if you already own 500 company shares, you can swap those shares such that; 500 shares x $40 = $20,000 for the 1,000 new shares, instead of paying $20,000 in cash.

Alternatively, you may be able to borrow funds that are needed to exercise your ISO stock options from your broker and sell at least a portion of the shares to cover your costs. This is referred to as the cashless exercise and while it has its advantages, it also disqualifies you from favorable tax treatment.

You, however, do not have to exercise your incentive stock options immediately and sell. You can as well hold on to your unexercised options until the expiry date draws nearer. Or you can exercise your incentive stock options (ISO) and hold on to the stock indefinitely especially if you have confidence in the future prospects of your company.

Incentive stock option key dates

  1. Grant date
  2. Vesting date
  3. Expiration date

These are the key dates that employees should keep track of with regard to their incentive or qualified stock options. These dates are important because they determine when stock options vest when they can be exercised, and when the employees do not have the right to execute the options any longer.

Grant date

The ISO stock option grant date is the date on which the shares were allocated. The grant date is also the date on which the shares are normally valued and determined by the exercise price. The purchase of these shares of stock takes place through the option at a price which is known as the exercise price. However, the grant date is not always the time when the option can be exercised to buy the shares.

Vesting date

The vesting date is the date when the incentive stock options become available to the employees. The number of options that vest is dependent on the terms of the incentive stock option plan agreement. There are certain plans that allow a set date when all the incentive stock options must be vested, and others allow a certain number of shares to be distributed over a period of time.

Expiration date

The expiration or expiry date is the final day when the employees can exercise their right to purchase their shares at the exercise prices. If the expiration date passes while the options are not exercised, the incentive stock options will cease to exist and this results in a missed opportunity as well as lost income.

See also: Types of Stocks: Different Classes of Stocks

Characteristics of ISO stock options

  1. Schedule
  2. Vesting
  3. Exercise method
  4. Bargain element
  5. Clawback positions

In terms of form and structure, ISO stock options are similar to non-statutory stock options.

Schedule

ISO stock options are issued on a beginning date which is known as the grant date. The employees then exercise their rights to buy the stock options on the exercise date. Once the options are exercised, the employees are free to either sell immediately or wait for a period of time before doing so. The offering period for incentive stock options is usually ten years after which the options expire.

Vesting of ISO stock options

Statutory stock options contain a vesting schedule that has to 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 the options that have been issued to them during that time. Other employers make use of the graded vesting schedule that allows employees to become invested in one-fifth of the options that are granted each year, starting in the second year of the grant. It is then that the employee becomes fully vested in all of the options in the sixth year of the grant.

Exercise method

ISO stock options also look like non-statutory stock options in the sense that they can be exercised in several ways. The employee can pay cash upfront in order to exercise them, or they can be exercised in a cashless transaction known as cashless exercise, or they can be exercised by the use of a stock swap.

Bargain element

Qualified stock options can usually be exercised at a price that is below the current market price which in turn provides an immediate profit for the employee.

Clawback provisions

These are conditions that give room for the employer to recall the options such as if the employee leaves the company for any reason aside from death, disability, or retirement, or if the company itself becomes unable to meet its financial obligations with the options.

See also: Capital Market Instruments, Examples, and Types

Incentive stock options tax treatment

Incentive Stock Options have more favorable tax treatment than nonqualified stock options because they require the holder to hold the stock for a longer period of time. This is the same with regular stock shares as well. Although these stock options have tax advantages, there are requirements to follow in order to gain the greatest benefit.

It is necessary for stock shares to be held for the profit on their sale to qualify as capital gains rather than ordinary income.

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

ISO stock options are not taxed when granted upon vesting, or when exercised. The taxes are deferred until the sales of the shares, and if certain holding requirements are held, incentive stock options are subject only to capital gains taxes. This is different from NSOs which are taxed upon exercise at income tax rates and also with capital gains taxes when shares are sold.

After exercising your stock options and purchasing shares, waiting over a year from the exercise date and at least two years after the grant date implies that you will meet the requirements for a qualifying disposition. This means that your transaction will then become eligible for preferential tax treatment and you will owe only long-term capital gains taxes.

Selling your shares before the end of the holding period brings about a disqualifying disposition and is likely to subject you to pay ordinary income taxes on the bargain element as well as short-term capital gains taxes.

As it is with non-statutory stock options, there are no tax consequences at either grant or vesting. However, the tax rules for their exercise are different from non-statutory options. An employee who exercises a non-statutory stock option has to report the bargain element of the transaction as earned income that is subject to withholding tax. At this point, the holders of ISO stock options will report nothing. In essence, there is no tax reporting of any kind until the stock is sold.

It is important to note that employers are not required to withhold any tax from ISO exercises, so those intending to make a disqualifying disposition should take care to set aside funds to pay for federal, state, and local taxes, and also social security, medicare, and FUTA.

See also: Stock and Shares Differences and Similarities

How to report incentive stock options and AMT

Although qualifying ISO dispositions can be reported as long-term capital gains on the IRS form 1040, the bargain element at exercise is also a preference item to the alternative minimum tax. This tax is then assessed to filters that have large amounts of certain types of income such as ISO bargain elements or municipal bond interest and it is designed to make sure that the taxpayer pays at least the minimal amount of tax on income that otherwise would be tax-free. This can be calculated on IRS Form 6251, however, employees who exercise a large number of ISOs should consult a tax or financial advisor beforehand in order for them to be able to properly anticipate the tax consequences of their transactions. The proceeds from the sale of ISO stock have to be reported on IRS form 3921 and then carried over to Schedule D.

Although one can achieve favorable capital gains tax treatment on his ISO stock options, it is necessary for the bargain element earned to be reported as taxable compensation and may trigger the alternative minimum tax (AMT). This ensures that certain high-earning taxpayers pay at least the minimum level of income tax.

Incentive stock options examples

Example 1

An employee purchased an option of 100 shares at $1 per share which is the strike price. Altogether, he pays $100 and the vesting period is four years. Four years later, the stock is selling at $10 per share on the stock exchange which means that the employee made a $9 profit on each share that was purchased if the option was exercised.

Example 2

If for example, George receives 1,000 non-statutory stock options and 2,000 incentive stock options from their company. For both options, the exercise price is $25. They exercise all of both forms of options about a year and a month later. When the stock starts trading at $40 per share, they sell 1,000 shares of stock from their incentive options six months later, for $45 per share. Eight months later, they sell the rest of the stock at $55 per share.

The first sale of ISO stock options is a disqualifying disposition, which means that George will need to report the bargain element of $15,000, that is $40 actual share price – $25 exercise price = $15 x 1,000 shares, as earned income. It will be necessary for them to do the same with the bargain element from the non-statutory exercise, with this, they will have $30,000 of additional W-2 income to report in the year of exercise. However, they will only report a long-term capital gain of 30,000, that is, $55 sale price – $25 exercise price x 1,000 shares for their qualifying ISO stock options disposition.

See also: Advisory Shares Meaning and Example

Cashless exercise for incentive stock options

A cashless exercise for incentive stock options is a transaction in which an employee exercises their stock options by making use of a short-term loan provided by a brokerage firm. Here, the proceeds from exercising the stock options are then used to make the loan repayment. With respect to this, a cashless exercise is similar to buying shares on margin.

In essence, it is brokers that make a cashless exercise possible who will lend money to employees which they will use to exercise their options.

This method of exercising stock options has become popular among employees who are eligible to participate in employee stock options plans (ESOP). It is most common among publicly traded companies because of their greater liquidity.

Most private companies are unable to accommodate cashless exercise because they have insufficient liquidity. However, they may be able to achieve similar results by making use of other mechanisms which include the issuance of promissory notes. They are similar to the loan that a broker would provide in a regular cashless exercise.

Incentive stock option requirements

In order to qualify as an ISO stock option, the following requirements have to be met;

  1. It is necessary for the terms of the option not to provide that the option will not be treated as an ISO.
  2. The option has to be granted to an individual in connection with that person’s employment by the corporation that is granting the option or by a related corporation as made definite in Treasury Regulation Section 1.421-1(i)(2).
  3. It is a must for the option to be for the purchase of the stock of the employer or a related corporation.
  4. The option has to be granted under a formal plan which may either be in written or electronic form that is approved by shareholders of the granting corporation within twelve months before or after the date of the adoption of the plan by the corporation.
  5. The plan under which the ISO stock options are granted must include a minimum aggregate number of shares that may be issued through the exercise of ISOs. It should also include the employees or class of employees who are eligible to receive options as well as other stock-based awards under the plan. If non-employees are eligible to receive stock-based awards under the plan, then the plan must separately designate the employees or class o employees that are eligible to receive ISOs.
  6. The option must be granted within the time frame of ten years from the earlier period the date the plan was adopted or the date that shareholders approved the plan.
  7. It is required for the terms of the option to state that the option cannot be exercised beyond ten years after the date the option was granted. Or five years after the option has been granted to the employee who possesses shares accounting for 10% or more of the total combined voting power of all classes of the corporation’s stock, its parent, or its subsidiary (10% shareholder)
  8. The exercise price of the stock option must not be less than the underlying shares’ fair market value on the grant date for employees who are not 10% shareholders or 110% of the underlying shares’ fair market value on the grant date for employees who are 10% shareholders.
  9. It is required for the terms of the option to prohibit the transfer of the option by the employee other than by will or the laws of descent as well as distribution. The terms must provide that the option can be exercised only by the employee during his lifetime.
  10. For each of the employees, the aggregate fair market value which is determined as of the grant date of the incentive stock option that becomes exercisable for the first time in any calendar year must not exceed $100,000.
  11. The holder of the option must be an employee of the corporation that is granting the option or a related corporation at all times during the period beginning from the grant date and ending on the date that is three months prior to the date of exercise. This implies that except in the case of the termination of the employee as a result of death or permanent total disability if the employment of the option holder terminates, the option holder must have to exercise the option not later than three months after the employee’s termination date.
  12. If the employment of the employee terminates as a result of total disability, the option must be exercised not later than one year after the employee’s termination date.
  13. If the termination occurs as a result of death, the heirs of the option holders can exercise the option until the option’s expiration date.

Incentive stock options vs RSU

Below are the major differences between ISO stock options and RSUs;

ISOs provide the employee the right to buy shares at a specific price while RSUs are structured in nature such that the employee receives a certain number of shares after being at a company for a certain period of time. The difference here is that RSUs are beyond an option, they are issued no matter what.

With incentive stock options, an employee needs to purchase the shares at the exercise price. On the other hand, when an employee receives RSUs and vests, there is no need to make a payment in order to purchase the stock.

ISO stock options are only taxable when the stock is sold while RSUs become taxable when they vest.

A video describing ISO stock options.
Joy Sunday Zaleng
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