What Are Incentive Stock Options (ISOs)?

In
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by Eric Smith, CFP®
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June 11, 2024
Incentive Stock Options (ISOs) are valuable for employees, offering potential financial rewards and preferential tax treatment. Learn what ISOs are and how they can benefit you.

Incentive Stock Options (ISOs) are a form of stock option that employers can grant to their employees. A stock option is a right to buy a specified number of the company’s shares at a specified price for a certain period. ISOs, or qualified or statutory stock options, must meet specific requirements under tax laws to qualify for preferential tax treatment.

Tax Law Requirements for ISOs

To qualify for the preferential tax treatment, ISOs must meet the following requirements:

  1. Strike Price: The strike price, or the price you will pay to purchase the shares, must be at least equal to the stock’s fair market value on the date the option is issued.
  2. Employee Status: To receive options, you must be an employee of the issuing company.
  3. Exercise Date: The exercise date cannot be more than 10 years after the grant date.
  4. Ownership Limitation: Special rules apply if you own more than 10 percent of your employer’s stock (by vote).

Once granted a stock option, you can buy the stock at the strike price, even if the value of the stock has increased. You must exercise the option within the specified time frame set when the option was granted. However, you are not required to exercise a stock option.

Why Employers Offer ISOs

Employers offer ISOs to:

  • Reward employees’ performance
  • Encourage longevity within the company
  • Give employees a stake in the company’s success

The other type of employee stock options, known as nonqualified stock options (NSOs), receive different tax treatment than ISOs.

Vesting Schedules and Exercising Options

Your options may be subject to a vesting schedule developed by the company. Unvested options cannot be exercised until a future date, often tied to your continued employment. The stock you receive upon exercising an option may also be subject to a vesting schedule.

Preferential Tax Treatment

If a stock option satisfies the tax law requirements for an ISO, preferential tax treatment is available for the sale of the stock acquired upon exercising the ISO. However, this preferential treatment only applies if the stock is held for a minimum holding period:

  • Two-Year Rule: You must hold the shares for at least two years from the date the option was granted.
  • One-Year Rule: You must also hold the shares for at least one year after the date you exercised the option.

Meeting these holding period requirements allows the stock sale to be taxed as a long-term capital gain rather than as ordinary income, potentially resulting in significant tax savings.

Understanding Stock Options with a Financial Professional

In conclusion, ISOs offer employees valuable opportunities to participate in their company’s growth while benefiting from favorable tax treatment. Understanding the rules and requirements associated with ISOs is crucial for maximizing this employee benefit. Consider consulting with a financial advisor for personalized advice and navigating the complexities of stock options.

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