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What the IRS Says About Incentive Stock Options

Incentive stock options (ISOs) offer compensation to employees with favorable tax advantages. Employers and employees need to understand the IRS criteria for ISOs to fully benefit from such a program.

ISO Definition

An ISO is an option granted to an employee by his or her employer to purchase stock in the employer corporation (or parent or subsidiary) at a stated price. In order for a stock option to qualify as an ISO, and thereby receive preferential tax treatment, it must be granted under a written plan. The terms of both the plan and the option must satisfy certain Internal Revenue Code requirements.

For Employees

The chief benefit of ISOs to employees is that there is no regular tax at the time the ISO is granted or when it is exercised. However, ISOs affect income at the time of exercise for purposes of the alternative minimum tax. ISOs must meet certain conditions imposed by the IRS Code to receive preferential tax treatment. For example, ISOs may not be transferred. The preferential tax treatment may be lost if an employee, after having exercised the ISO, sells or otherwise exchanges the stock within one year of exercising the option or within two years of receiving the option grant. In addition, the employee must have been employed by the grantor corporation (or its parent or subsidiary) at all times beginning on the date of the option grant until three months before the exercise of the ISO. Certain restrictions relating to the option price and the dollar value of options that may be granted also apply. Finally, the difference between the option price and the fair market value of the option stock when the option is exercised is subject to the alternative minimum tax.

For Employers

From the employer’s standpoint, the benefits of ISOs include: (1) the ability to give the employee a productivity incentive in the form of a stake in the business; and (2) the fact that the grant of an ISO entails no cash outlay. The chief detriment of ISOs to the employer is that an employer may not take a compensation deduction with respect to the option stock, unless the employee sells the stock before the end of the required holding period. An employer must also satisfy certain IRS Code requirements. For example, the ISOs must be granted under a plan approved by the corporation’s stockholders within 12 months before or after the plan’s adoption. The option must also be granted within ten years of the date the plan is adopted or the date the plan is approved by the shareholders, whichever is earlier. Further, the option by its terms must be exercisable only within ten years of the date it is granted.

Some of the incentive stock options rules are complex and require informed judgment to determine whether a particular stock option qualifies and, if so, how it will be taxed. In situations like this, it’s a good idea to talk with a Salmon Sims Thomas tax advisor.