Introduction to Incentive Stock Options

Incentive stock options, or ISOs, are a type of employee stock option used in equity-based compensation strategies. They are also known as statutory stock options because they are subject to a strict set of regulations. ISOs qualify for special favorable tax treatment under the Internal Revenue Code if certain requirements are met. For instance, there is a $100,000 limit on the value of ISOs that become exercisable for an employee in any calendar year. ISOs can be granted to employees only (not outside consultants or contractors), and an employee cannot own ISOs representing more than 10 percent of the voting power of the company.

The option price (also known as the exercise price) is determined by the value of the company’s stock on the day the option is granted. For example, if the market price of the stock (or, if there is no market price, the share price determined by formula or appraisal) is $10, then the exercise price for each option would also be $10. Employees have a fixed period of 10 years in which to exercise an ISO after it has been granted. Some plans may have a vesting schedule, meaning that employees cannot immediately exercise their options. To retain favorable tax treatment, ISOs must be exercised within three months after an employee terminates employment.

How are ISOs taxed?

Employees don’t recognize taxable income upon the grant of an ISO. Plus, unlike with nonqualified stock options, the exercise of an ISO doesn’t result in taxable income for the employee. If you hold the stock for at least two years after the option grant date and one year from the exercise date, all appreciation of the share price over the exercise price will be taxed at the long-term capital gains rate. When you exercise an ISO, your company will not withhold taxes, nor will the exercise be subject to social security and Medicare taxes.

Please note: If you sell a share acquired through the exercise of an ISO before meeting the holding period requirements (two years from grant date and one year from exercise date), the sale becomes a disqualifying disposition. In this case, you will be subject to ordinary income tax on the difference between the exercise price and the sale price, also referred to as the spread, which will be added to your Form W-2.

Keep in mind that, although you don’t recognize taxable income upon exercising an ISO, the spread must be included as income received for the purpose of calculating your alternative minimum tax (AMT). The spread is not reported on your Form W-2, but you must include it in the AMT calculation when preparing your taxes.

Tax tip: Careful management of ISOs is essential. Prematurely selling shares acquired via an ISO grant will result in a violation of the holding period requirements and loss of favorable tax treatment. Maintaining accurate records will help you monitor the bases for regular tax and AMT, as well as keep track of available AMT credit.

Examples

Scenario 1: Exercise ISO and sell one year after exercise and two years after grant

Grant date: January 2013
Option price: $10
Exercise date: June 2015
Fair market value on date of exercise: $30
Sale date: December 2016
Sale price: $50
Options exercised: 100

Tax result:

At exercise

Reportable income to employee on Form W-2: $0
Reportable income for AMT calculation: $2,000 [($30 – $10) x 100]
Tax basis for regular tax: $10 per share; for AMT: $30 per share

At sale

Reportable gain for regular tax: $4,000 [($50 – $10) x 100]
Reportable gain for AMT: $2,000 [($50 – $30) x 100]
Because the shares were held for more than one year after exercise, the gains for both (regular tax and AMT) will be taxed at the long-term capital gains rate.

Scenario 2: Exercise ISO and sell before required holding period is up (disqualifying disposition)

Grant date: January 2013
Option price: $10
Exercise date: June 2015
Fair market value on date of exercise: $30
Sale date: December 2015
Sale price: $35
Options exercised: 100

Tax result:

At exercise

Reportable income to employee on Form W-2: $0
Reportable income for AMT calculation: $2,000 [($30 – $10) x 100]
Tax basis for regular tax: $10 per share; for AMT: $30 per share

At sale

Reportable income to employee on Form W-2: $2,000 [($30 – $10) x 100]
Tax basis: $30 per share
Additional gain of $5 per share ($35 – $30) taxed as a short-term capital gain

Tax tip: Your tax basis in the stock is determined by what you paid to exercise the option plus the amount of W-2 compensation. Any appreciation of the stock between the exercise date and the date of sale is treated as a short-term capital gain when the share is sold within one year of exercise.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

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Sara Romaine is a financial advisor located at Blue Hills Wealth Management, 300 Crown Colony Drive, Quincy MA 02169. She offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. She can be reached at 617-471-6800 or sara@bluehillswm.com.