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,
Junior Common Stock,
Plans, Qualified Stock Option Plans,