Incentive Stock Options (ISOs) are a common form of incentive tied to the equity of a private or public company. ISOs provide employees with the opportunity to purchase company stock at a predetermined price, known as the exercise price. Although ISOs present a great opportunity to participate in the success of a company, there are some aspects of this type of compensation that can present additional complexity.
Tax Treatment
ISOs are subject to specific IRS rules, and not all employees are eligible. Check with your benefits provider to understand if you meet qualification criteria.
Exercise and Holding Periods: To receive favorable tax treatment, an employee must meet certain holding requirements. Shares acquired through ISOs must be held at least two years from the grant date and one year from the exercise date.
Tax at Exercise: Employees are not subject to regular income tax when they exercise ISOs. However, the difference between the exercise price and the fair market value of the stock at the time of exercise (known as the "spread") may be subject to the alternative minimum tax (AMT).
Tax at Sale: If an employee meets the ISO holding period requirements, the gain from selling the ISO shares is typically taxed as a long-term capital gain, which is typically a lower tax rate than ordinary income. If the holding period requirements are not met, the gain is taxed as ordinary income.
Risks
Lack of Diversification: The value of ISOs is directly tied to the company's stock price. If the stock price falls, the options may become worthless or have significantly reduced value.
Tax Complexities: Employees may inadvertently trigger adverse tax consequences if they do not adhere to the holding period requirements.
If properly managed, ISOs can be a powerful tool for building personal wealth and achieving financial goals, but they require careful planning and a thoughtful risk and tax strategy.
