Incentive Stock Options – Equity Compensation at Private Firms

To finish off our Equity blog series, we will take a look at Incentive Stock options (ISOs).

Incentive stock options are structured just like non-qualified stock options on the front end, but receive preferential tax treatment if certain conditions are met when an employee exercises the stock options and ultimately sells the stock.

Let’s look at an example

Let’s consider Jill, who becomes an employee of XYZ Company in June 2018 and is given an incentive stock option for 1,000 shares at a grant/exercise/strike price of $5. Shares will vest at 25% per year:

• June 2018: Stock option granted
• June 2019: 250 shares vested
• June 2020: 250 shares vested
• June 2021: 250 shares vested
• June 2022: 250 shares vested

In June 2022, all 1,000 shares of XYZ Company’s stock have vested. Jill decides to exercise her option to buy all 1,000 shares at her grant price of $5 per share when the value of XYZ Company’s stock is $50 per share.

Jill writes her company a check for $5,000 (1,000 shares x $5 per share), and the company in returns gives Jill 1,000 shares of stock. Jill is now officially a stockholder.

With an incentive stock option, Jill would not have to pay taxes on the $45,000 IF she held on to the stock for at least a year after she exercised her options.

This is the most significant benefit of an incentive stock option: Jill will only pay long-term capital gain on the stock when she sells.

If Jill does not wait more than 1 year before selling her stock, she WILL pay ordinary income taxes on the $45,000 bargain element AND any gain.

Form 3921: Jill’s employer will complete Form 3921, “Exercise of an Incentive Stock Option”, and submit it to the IRS whenever Jill exercises her option to buy company stock.

Conclusion

ISOs can prove beneficial to employees because 1) Regular federal income tax is not triggered upon exercise of ISOs (although AMT may be) and 2) Qualifying dispositions of ISOs (selling your stock) enjoy long-term capital gains treatment.

In order to qualify for long term capital gains, the option must be exercised during your employment and the shares issued upon exercise must be held for at least one year after the exercise date and at least two years from the date the option was originally granted.

ISOs can only be granted to employees (not to advisors, consultants or other service providers).

One final thought: make sure you explain to your employees that there are tax implications associated with their total compensation package and they shouldn’t wait until year-end to find out the amount of the tax.

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