ISOs (Incentive Stock Options) . . .

are rights to purchase company securities, usually common stock, which are issued to company employees and others the company wants to hire. ISOs are designed to attract new employees and motivate existing employees. They do this by giving the employee the right to purchase company shares in the future at present-day prices. If the company is successful, and its stock increases in value, the employee can purchase shares of company stock in the future at a price far below the then fair market value of the shares. By creating this potential "windfall," the incentive stock option motivates the employee to work hard to make the company succeed.

ISOs are issued under guidelines adopted by the company’s board of directors. These guidelines are commonly referred to as plans.

Federal tax laws recognize two types of ISO plans: qualified stock option plans and nonqualified stock option plans. Preferential tax treatment is given to the holders of options issued under qualified plans. The preference is that there is no realization of income for federal income tax purposes when the option is issued by the company or exercised by the holder.

Employees who hold nonqualified stock options realize income, at ordinary income tax rates, when they exercise their options if the fair market value of the shares purchased exceeds the price they paid for the shares under their option. If the fair value of the shares when exercised is significantly greater than the option exercise price, the employee's tax obligation can be substantial. Since the employee’s profits in the stock may not be liquid (ie., the stock may be restricted or the market for the stock may be limited) he may have to pay those taxes from his other resources.

By contrast, qualified stock option holders incur no federal tax obligation until they later sell their stock at a profit. No income is realized when the option is issued or exercised. When the stock is later sold, the gain realized is taxed at capital gains rates. When capital gains rates are lower than ordinary income rates, as they are at this writing, the difference between paying taxes at ordinary income rates when a nonqualified option is exercised and being able to defer those taxes on a qualified option until the stock is sold and then only pay lower capital gains rates makes qualified options even more attractive.

Securing the benefits of qualification with the IRS requires careful planning and close attention to detail. Qualified options may be issued only under a plan that meets the requirements set out by the Internal Revenue Service. These include having the plan approved by the company’s shareholders within twelve months after it is adopted by the company’s board of directors. Qualified plans must also identify the types of employees who may receive options and the total number of shares that may be subject to options issued under the plan. Each option may have a term of no more than ten years and must be issued within ten years after the date the plan is adopted. Options may be issued only to employees. Except in certain limited circumstances, employees must exercise their options while they are employed by the company or within three months thereafter.

Further, qualified options may not be transferred except on death and their exercise price must be at least as great as the fair market value of the underlying stock at the time the option is issued. For any employee who holds 10 percent or more of the company’s stock, the exercise price must be at least 110 percent of the fair market value of the company’s stock when the option is issued, and the option term cannot exceed five years. The total fair market value of stock subject to qualified options that can vest in one employee in one year cannot exceed $100,000. 

Plan administrators (usually management) must be careful when they accept notes in lieu of cash payment when a qualified option is exercised. The notes must be full-recourse and must bear interest at least equal to minimum rates established by the IRS. If they do not, the IRS-imputed interest rules will apply. This will require the employee to pay tax on the imputed interest and may, because imputed interest is not included in the option exercise price, cause the latter to fall below fair market value. If it does, the option may not be treated as qualified.

Any incentive stock option plan that does not meet all of the IRS requirements is treated by the IRS as nonqualified plan. This means the employee will not receive the tax advantages of holding qualified options. However, they also will not be subject to the $100,000 value limitation or to the requirement that they be employees. Nor must the term of their options be tied to employment. And, below-market interest rate loans used to exercise options will not have a disqualifying effect. If the employee is sufficiently wealthy to pay the taxes, or if the term of the option is long enough to permit him to exercise the option after the company’s and his stock becomes tradable in the public market, the nonqualified stock option may still create a viable incentive for the employee.

Nonqualified options issued to employees also entitle the issuing company to deduct against its income tax obligations an amount equal to the compensation income attributed to the employee upon the exercise of the option. The amount of this deduction is the same as the amount of income attributed and taxed to the employee because of his exercise of the option, the difference between the option exercise price and the fair market value of the shares purchased. In order to obtain the deduction, however, the company must be sure to withhold the proper amount from the employee’s income.

The use of options should be considered carefully so they can be tailored to fit the employee’s and the company’s needs. Qualified stock options can be used to advantage in most situations and can benefit the employee by giving him the opportunity to share in the future appreciation of the company’s stock without adverse tax consequences. To qualify the options the employee receives, however, the company and its management must be careful to structure the option plan to meet all of the IRS’s requirements. This usually means engaging a qualified professional to establish and administer the plan.

Also, certain individuals, particularly those who are attempting to shelter income from federal taxation, must be careful to consider the alternative minimum tax (AMT) consequences of obtaining rights under a qualified plan. The difference between the holder’s exercise price for the shares in a qualified plan and the fair market value of those shares when he exercises the option is a potential tax preference item that may become subject to the alternative minimum tax. The application of the AMT rules can make qualified options less attractive to these individuals. Those persons with AMT concerns should consult their tax adviser before accepting qualified stock options. See: Board Committees, Compensation and Bonus Plans, Golden Handcuffs, Junior Common Stock, Options, Phantom Stock Plans, Qualified Stock Option Plans, Warrants.