Know Your (Incentive Stock) Options

David Uhlmann |

Incentive Stock Options (ISOs) are a type of stock option that provides tax benefits to employees. They are a popular form of employee compensation, especially in startups and technology companies, where employees are given the opportunity to purchase stock in the company at a discounted price. In this blog, we will discuss the tax impact of ISOs, the benefits they offer, and how they differ from other types of stock options.

What are Incentive Stock Options?

ISOs are a type of stock option that allows employees to purchase stock in the company at a discounted price, known as the exercise price. The exercise price is set at the time the option is granted, and the employee has a certain period of time to exercise the option, typically 10 years. If the company's stock price increases, the employee can sell the stock and make a profit, which is known as a capital gain.

The Tax Benefits of ISOs

One of the key benefits of ISOs is that they are taxed differently than other forms of stock options. With ISOs, the employee is not taxed on the exercise of the option, but only when they sell the stock. If the stock is held for more than one year, the capital gain is taxed as long-term capital gain, which is taxed at a lower rate than ordinary income. This means that the employee can potentially pay a lower tax rate on the profit they make from the sale of the stock.

Furthermore, if the employee meets certain conditions, they may be eligible for what is known as the "ISO Holding Period Requirement." If the employee holds the stock for more than two years from the date of grant and one year from the date of exercise, they will be eligible for the ISO Holding Period Requirement. In this case, the capital gain from the sale of the stock is taxed as long-term capital gain, regardless of how long the stock was held.

However, the alternative minimum tax (AMT) can sometimes impact the tax benefits of ISOs. The AMT is a separate tax system designed to ensure that taxpayers with high income and substantial deductions pay at least a minimum amount of tax. When an ISO is exercised, the spread between the exercise price and the stock's fair market value is added to the taxpayer's taxable income for the year, which can trigger the AMT. As a result, the taxpayer may have to pay the AMT on the spread, even though they have not yet sold the stock and are not yet eligible for the long-term capital gains treatment.

It's important to consider the potential impact of the AMT on ISOs when making decisions about exercising and selling stock options. It's recommended to consult with a financial or tax advisor for personalized advice.

The Difference between ISOs and Non-Qualified Stock Options (NSOs)

ISOs are different from Non-Qualified Stock Options (NSOs), which are taxed as ordinary income when exercised. This means that the employee is taxed on the difference between the exercise price and the fair market value of the stock at the time of exercise. Additionally, the employee must pay Social Security and Medicare taxes on the taxable income, which can result in a higher tax bill.

NSOs are also subject to different restrictions than ISOs. For example, there may be limits on the amount of NSOs that can be granted, and there may be vesting requirements that must be met before the option can be exercised.

In conclusion, ISOs offer a tax-advantaged way for employees to participate in the success of the company. They provide the opportunity for employees to purchase stock at a discounted price, and the tax benefits allow employees to potentially pay a lower tax rate on their capital gains. Understanding the tax impact of ISOs is important for employees as it can help them make informed decisions on the timing of exercise and sale.


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