Incentive Stock Options: The Qualifications and Limitations

In startup land, aside from cash compensation, stock options are the most important part of employee compensation. (This is the case because once a startup is beyond the very early, initial startup phase, no other form of equity compensation–such as restricted stock or RSUs–works very well from a tax point of view for employees.)

Because equity compensation is such an important part of your overall employee compensation, it is important to maximize the benefit of your stock option plan to your employees.

How do you do this? Well, probably the most important thing to do is clearly communicate with your employees on the type of options they are receiving, what their options entitle them to, and how they work.

Employees frequently have a lots of questions about their options, including questions on how they work, and the tax consequences to them of receiving and ultimately exercising the options.

There are only two types of stock options: incentive stock options (ISOs) and nonqualified stock options (NQOs).

You will have to choose what type of options to grant.

ISOs have certain special tax advantages to employees over NQOs, but those employee advantages come at a cost (and potentially a significant one) to the company.

What Are the Advantages to the Employee of an ISO?

  • No ordinary income tax on exercise
  • No employment tax on exercise
  • If two holding periods are met, long term capital gain on sale
  • If the holding periods are not met, if there was spread on exercise, you will have ordinary income equal to that amount on sale of the stock, and if there is gain beyond that, short term capital gain on that portion, but still no employment tax withholding.

Nonqualified stock options trigger income and employment tax withholding on exercise, if there is a spread on exercise. This is arguably a benefit of an NQO over an ISO because it is easier to calculate the income and employment taxes on an NQO exercise than the Alternative Minimum Tax (“AMT”) consequences of an ISO exercise.

The Costs to the Employer of an ISO

  • The loss of the deduction of the spread on exercise.
  • In contrast, with a nonqualified stock option, the company gets to deduct the spread on the exercise of an NQO. This can be a significant tax benefit to a profitable company.

The Qualifications and Limitations

If you decide you want to grant ISOs, you will need to know the various qualifications and limitations of ISOs.

Again, these qualifications and limitations are in exchange for the special tax advantages an ISO provides to employees over nonqualified stock options.

The ISO qualifications and limitations are:

  • ISOs can only be granted to employees. So independent contractors and members of the board of directors who aren’t otherwise employees can’t receive ISOs.
  • Only the first $100,000 that becomes exercisable during any 12 month period can qualify for ISO treatment.
  • ISOs to 10% or greater stockholders have to be priced at 110% of FMV and have no more than 5 year term.
  • The spread on the exercise of an ISO is not subject to ordinary income tax and employment tax withholding but the spread on exercise is an AMT adjustment.
  • The spread on the exercise of an ISO is not deductible to the company.
  • ISOs have to be granted pursuant to a plan that specifies the aggregated number of shares that may be issued under options and the employees or class of employees eligible to receive options, and which is approved by the shareholders within 12 months before or after the date the plan is adopted.
  • ISOs have to be granted within 10 years from the date the plan plan is adopted, or the date such plan is approved by the stockholders, whichever is earlier.
  • ISOs cannot be exercisable after the expiration of 10 years from the date such option is granted.
  • ISOs have to be granted with an option price not less than the fair market value of the stock at the time such option is granted.
  • ISOs cannot by their terms be transferable otherwise than by will or the laws of descent and distribution, and may be exercisable, during the optionee’s lifetime, only by the optionee.

The Full Benefit of ISOs is Rarely Realized

Probably the most important thing to know about ISOs is that most of the time the primary benefits of an ISO are not realized by the employee. Most employees don’t exercise their options until and in connection with a liquidity event—at which time they will not have satisfied the two holding periods. Nevertheless, even in that context, there are employment tax savings (although these might be relativity small, they still exist).

This blog does not constitute legal or tax advice.

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