Incentive Stock Options (ISOs)

Incentive Stock Options (ISOs)

What they are
* Incentive stock options (ISOs), also called statutory or qualified stock options, give employees the right to buy company stock at a fixed strike (exercise) price.
* They’re typically used for management and key employees as a compensation and retention tool. The value to the employee depends on the company’s future share price.

How ISOs work
* Grant and strike price: The company grants options with a strike price (usually the market value at grant).
* Vesting: Options typically vest according to a schedule (examples: three-year cliff or graded vesting over several years). Vesting must be satisfied before exercise.
* Exercise: Once vested, an employee can exercise the options (buy shares at the strike price). Options generally expire 10 years from grant.
* Post-termination window: To preserve ISO status, options generally must be exercised within three months after termination of employment (exceptions often apply for death, disability, or retirement).
* Clawbacks: Some plans allow the employer to reclaim options under specified conditions.

Tax treatment — why ISOs are attractive
Key rule for favorable tax treatment:
* To get capital gains treatment on the entire gain, you must meet both holding periods:
* Hold at least two years from the grant date, and
* Hold at least one year after the exercise date.
Tax consequences by stage:
* Grant: No immediate tax.
* Exercise: The “bargain element” (fair market value at exercise minus strike price) is not ordinary income for regular tax purposes if you retain the shares, but it is a preference item for the alternative minimum tax (AMT) and can trigger AMT liability.
* Sale:
* Qualifying disposition (meets both holding periods): Gain is taxed as long-term capital gain.
* Disqualifying disposition (sold before holding periods are met): The bargain element is treated as ordinary income; any additional gain/loss is taxed as capital gain/loss depending on holding after exercise.
Employer tax treatment:
* If the employee makes a qualifying disposition, the employer receives no tax deduction.
* If the employee makes a disqualifying disposition, the employer can usually deduct the bargain element as compensation expense.

Example (brief)
* Grant 100 options at $10 strike. Years later, FMV = $30 at exercise.
* Bargain element at exercise = $20 per share.
* If you hold and sell after meeting the holding requirements, the $2,000 total gain (100 × $20) is long-term capital gain. If you sell earlier, part or all of that $2,000 becomes ordinary income.

Risks and considerations
* Market risk: If the stock price falls below the strike, options may be worthless.
* Timing risk: Waiting to satisfy holding periods may expose you to stock-price volatility.
* AMT risk: Exercising large ISOs can create significant AMT exposure in the year of exercise.
* Concentration risk: Large option positions can concentrate wealth in one company.

ISOs vs. Non‑Qualified Stock Options (NSOs)
* Taxation at exercise:
* ISOs: No ordinary income if shares are held; potential AMT adjustment at exercise.
* NSOs: Bargain element taxed as ordinary income at exercise and subject to withholding.
* Employee eligibility:
* ISOs: Generally limited to key employees and executives.
* NSOs: Can be granted broadly to employees, contractors, advisors.
* Employer deduction:
* ISOs: No deduction for employer if employee makes a qualifying disposition.
* NSOs: Employer gets a deduction when the employee recognizes ordinary income.
* Exercise mechanics: Both may allow cash exercise, cashless exercise, or stock swap methods, but tax and withholding differ.

Limits and rules
* Per-employee annual limit: No more than $100,000 of ISOs (measured by the aggregate fair market value of stock exercisable for the first time in a calendar year) can qualify as ISOs for a given employee under the tax rules.
* Expiration: ISOs typically expire 10 years after grant.
* Eligibility restrictions and post-termination exercise windows exist to preserve ISO tax status.

Cashless exercise
* A cashless exercise lets an employee exercise options without paying cash up front by simultaneously selling some or all of the acquired shares to cover the exercise price, taxes, and fees. This is a common way to realize value without out-of-pocket funds.

Practical tips
* Check your plan document for vesting, post-termination exercise windows, and clawback provisions.
* Coordinate exercise and sale timing with tax planning—consult a tax advisor about AMT and potential withholding consequences.
* Consider diversification: avoid holding too much company stock after exercising.
* Keep records of grant dates, exercise dates, strike prices, and fair market values at exercise to determine tax outcomes.

Bottom line
ISOs can provide favorable tax treatment and strong incentives for employees to build company value, but they carry timing, market, concentration, and AMT risks. Understand your plan’s rules and the tax holding-period requirements (two years from grant and one year from exercise) before exercising or selling.