05 Jan What's so incentivizing about the incentive stock option?
Madison, Wis. – My last column covered the classic stock option (the “NSO”), which is subject to fewer rules, but which is also generally less tax-advantageous for the recipient. Now it is time to turn our attention to the type of option more commonly found in early-stage and technology companies: the incentive stock option, commonly called an “ISO.”
The ISO is an animal created by statute. To discern how these differ from non-statutory options, we must take a trip through the Internal Revenue Code. Here is the litany of requirements for an option to be treated as an ISO by the IRS:
• The employer must have a written plan that lays out some required specifics, including the eligible employees and the number of shares that can be issued (which we will not go into here).
• The written plan must be adopted by the company’s board of directors AND its shareholders (note here that only corporations can issue ISOs; this is not a benefit that can be conferred by an LLC).
• The option exercise price must be at least equal to the fair market value of the underlying shares on the date the options are granted to the employee. I will go into this key factor more in a future column. (For employees who own more than 10 percent of the company, the exercise price must be at least 110 percent of the fair market value.)
• The option cannot be exercised more than 10 years after it is granted. (For employees who own more than 10 percent of the company, the period is shortened to five years.)
• The option cannot be granted to anyone other than an employee (unlike non-statutory options, which can be granted to independent contractors and board members).
• If an employee terminates employment for most reasons, she or he must exercise the ISO within three months of such termination.
• The employee cannot transfer the ISO, other than at death.
• The ISO stock must be held for certain periods after grant and exercise (more on this below).
So, given this strict list of requirements, why bother with the ISO? Since the Internal Revenue Code created this animal, you probably won’t be surprised that the answer is taxes!
As I mentioned before, the primary drawbacks to the non-statutory stock option are that you typically must pay income tax when you EXERCISE the option (not when you later sell it) and you have to pay tax at regular INCOME TAX RATES. The ISO solves these problems. As long as the ISO is held for the statutory holding periods, you will pay tax only when you ultimately sell the shares you purchase under the option, and the entire gain or loss will be taxed at long-term capital gains rates, which continue to be considerably lower than income tax rates. This is a huge difference that can be very, very beneficial to the recipient.
In the last paragraph, I mentioned critical holding periods. This is the last requirement to get ISO treatment for your option, and it is important because it falls on the recipient for compliance, not the company. In order to get ISO treatment, the option recipient must not sell the stock purchased under the option for (a) two years from the date of the grant of the option and (b) one year from the date of the exercise of the option. Of significantly more importance to the recipient in most cases is the one-year holding period, which effectively requires that the recipient hold the stock for a year after exercising the option. This guards against many “strategic” option exercises and encourages more long-term investment in the company. If you do not abide by these holding periods, you will have made a “disqualifying disposition,” and your ISO will be taxed just like an NSO.
One other tax trap for the unwary involves the notorious alternative minimum tax, or AMT. This is a horribly complex issue. Recipients should be careful to work through these issues with their tax advisors before they exercise their ISOs. The basic rule is this: you will need to include in your income, for AMT purposes, the spread between your exercise price and the value of the shares at that point. In other words, although you will get long-term capital gains treatment for the ultimate disposition of the stock, the AMT can really cause problems in the year of exercise. So, work through the numbers before you exercise your ISO. For some strategies to minimize the AMT/ISO problem, check out this link.
Next: More detail
In our next couple of columns, we will look at the ISO rules in a bit more detail, especially the valuation issues swirling around ISOs granted by early-stage companies, and we’ll consider the effects of the new 409A rules on deferred compensation of all sorts, including stock options.
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