Incentive stock option

Incentive stock options (ISO's), are a type of employee stock option that can be granted only to employees and confer a U.S. tax benefit. ISO's are also sometimes referred to as incentive share options or Qualified Stock Options.

The tax benefit is that on exercise the individual does not have to pay ordinary income tax (nor employment taxes) on the difference between the exercise price and the fair market value of the shares issued (however, the holder may have to pay U.S. alternative minimum tax instead). Instead, if the shares are held for 1 year from the date of exercise and 2 years from the date of grant, then the profit (if any) made on sale of the shares is taxed as long-term capital gain. Long-term capital gain is taxed in the U.S. at lower rates than ordinary income. Although ISOs have more favorable tax treatment than non-ISOs (aka non-statutory stock option (NSO) or non-qualified stock option (NQSO)), they also require the holder to take on more risk by having to hold onto the stock for a longer period of time in order to receive the better tax treatment.

Note further that an employer generally does not claim a corporate income tax deduction (which would be in an amount equal to the amount of income recognized by the employee) upon the exercise of its employee's ISO, unless the employee does not meet the holding-period requirements. "But see" Coughlan, Section 174 R&E Deduction Upon Statutory Stock Option Exercise, 58 Tax Law. 435 (2005). With NQSOs, on the other hand, the employer is always eligible to claim a deduction upon its employee's exercise of the NQSO.

Additionally, there are several other restrictions which have to be met (by the employer or employee) in order to qualify the compensatory stock option as an ISO. For a stock option to qualify as ISO and thus receive special tax treatment under Section 421(a) of the Internal Revenue Code (the "Code"), it must meet the requirements of Section 422 of the Code when granted and at all times beginning from the grant until its exercise. The requirements include:

* The option may be granted only to an employee (grants to non-employee directors or independent contractors are not permitted), who must exercise the option while he/she is an employee or no later than three (3) months after termination of employment (unless the option holder is disabled, in which case this three-month period is extended to one year. In case of death the option can be exercised by the legal heirs of the deceased until the expiration date).

* The option must be granted under a written plan document specifying the total number of shares that may be issued and the employees who are eligible to receive the options. The plan must be approved by the stockholders within 12 months before or after plan adoption.

* Each option must be granted under an ISO agreement, which must be written and must list the restrictions placed on exercising the ISO. Each option must set forth an offer to sell the stock at the option price and the period of time during which the option will remain open.

* The option must be granted within 10 years of the earlier of adoption or shareholder approval, and the option must be exercisable only within 10 years of grant.

* The option exercise price must equal or exceed the fair market value of the underlying stock at the time of grant.

* The employee must not, at the time of grant, own stock representing more than 10% of voting power of all stock outstanding, unless the option exercise price is at least 110% of the fair market value and the option is not exercisable more than five (5) years from the time of the grant.

* The ISO agreement must specifically state that ISO cannot be transferred by the option holder other than by will or by the laws of descent and that the option cannot be exercised by anyone other than the option holder.

* The aggregate fair market value (determined as of the grant date) of stock bought by exercising ISOs that are exercisable for the first time cannot exceed $ 100,000 in a calendar year. To the extent it does, Code section 422(d) provides that such options are treated as non-qualified stock options.

See also

*Non-qualified stock options (NQSOs or NSOs)