Incentive Stock Options
There are generally two kinds of stock options: calls and puts. But have you heard of employee stock options? Employee stock options are like call options but the writer is the corporation, the holder is the employee and the share of stock involved are those of the corporation’s. There are two kinds of employee stock options: Incentive stock options (ISOs), also known as qualified or statutory stock options, and Non-qualified stock options (NQSOs) or Non-statutory stock options (NSOs). For purposes of this article, I will discuss ISOs.
ISO is a kind of employee stock option that is conferred only to an employee of the corporation and enjoys a tax benefit as defined by the United States Internal Revenue Code. The tax benefit confers upon the employee the freedom from paying additional income tax if ever the share price of the company’s stocks exceeds the strike price. However, an alternative minimum tax may have to be paid.
If the employee chooses to hold on to the shares of stock for one year after the date he exercised his stock options and two years from the date the stock option was granted to him then the employee also has to pay a long-term capital gains tax if he profits from those shares. Fortunately, long-term capital gains tax is still lower than the ordinary income tax.
According to Section 421 (a) of the Internal Revenue Code, an employee stock option will qualify as an ISO, and therefore eligible for a better tax treatment, if the following requirements are met:
- The stock option can only be given to an employee of the corporation and it must be exercised while the holder is still an employee of the corporation or three months after the termination of the employment. If the employee is disabled it can be exercised within 1 year after the termination of employment. If the employee dies before the expiration of the stock option his legal heirs are authorized to exercise the option.
- A written plan document that grants the stock options and specifies the total shares that may be bought by the employees and the names of the employees who will receive the stock options must be approved by the stockholders 12 months before the adoption of the grant or 12 months after the adoption.
- An ISO agreement must be executed stating that the option is granted to the employee and setting forth that the company offers the stock options for sale at a given strike price within a specified period it can be exercised. The ISO agreement must also enumerate the requirements met for the option to be ISO.
- The stock option can be conferred within ten years from the approval of the grant and must be exercised by the employee within 10 years.
- The strike price must be equal to or more than the prevailing share price of the company’s stock.
- At the time the option is conferred, the employee must not own the company’s stock that would give him 10% voting power.
- The ISO agreement must state that the stock option can be exercised only by the holder and that it can be transferred only by law or by will.
- Lastly, an employee cannot own $100,000 worth of stock in a year for the first time he will exercise the option. Otherwise it will be considered NSO.