Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
What is it?
A tax-favored plan for compensating executives by
granting options to buy company stock
If ISO meets IRS requirements, executive is taxed only
when stock sold
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
When is it Indicated?
For executive compensation in larger corporations
NOT appropriate for closely-held corporations
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
Advantages
1. greater tax deferral for executive than nonstatutory
stock option
2. income from sale of stock obtained through exercise
of ISO may be eligible for preferential capital gain
treatment
3. little to no out-of-pocket cost to company
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
Disadvantages
1. Granting corporation does not usually get tax
deduction at any time
2. must meet complex technical requirements
3. ISO exercise price must equal or exceed fair market
value of stock when option granted
4. executive must have cash to exercise option
5. executive may incur alternative minimum tax (AMT)
liability when ISO option exercised
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
Tax Implications
1. Executive is not subject to federal income tax on an
ISO when option granted or exercised; taxes
deferred until disposition of stock
2. To obtain this tax treatment for ISOs numerous
requirements must be met
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
Tax Implications
To obtain special tax treatment:
– options granted in written plan that specifies
• number of shares to be issued
• class of employees covered under the plan (no
nondiscrimination rules)
– only first $100,000 of ISO stock granted to any one
employee, which becomes exercisable for first time during
any one year, is entitled to favorable tax treatment
– options must be exercised within 10 years of grant
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
Tax Implications
To obtain special tax treatment:
– person receiving grant must be employed with granting
company at all times between grant of option and 3
months before date of exercise
– stock acquired by ISO must be held at least 2 years after
option granted and 1 year from date stock transferred to
employee
– no options issues more than 10 years from date ISO plan
adopted or approved (whichever is first)
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
Tax Implications
To obtain special tax treatment:
– option must not be transferable (except by will or descent
and distribution) an exercisable only by person receiving it
– corporate stockholders must approve ISO plan within 12
months of time adopted by company board of directors
– exercise price of option must equal or exceed fair market
value of stock on date option granted
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
Tax Implications
To obtain special tax treatment:
– ISA may not be granted to any employee who directly or
indirectly owns more than 10% of the corporation unless
• term of option is limited to not more than 5 yrs.
• the exercise price is at least 100% of the fair market value of
the stock on date of the grant
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
Tax Implications
3. Excess of stock’s fair market value over option price
at time of exercise is included in individual’s
alternative minimum taxable income
4. if stock held 2 yrs. after grant and 1 yr. after exercise,
gain on sale taxed at long-term capital gain rates
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
Tax Implications
5. If stock sold before 2 yr. / 1 yr. holding period, excess
of fair market value over exercise price is treated as
compensation income
6. Corporation gets
– no tax deduction for granting ISO
– no deduction when option exercised or stock acquired
under ISO sold
– a deduction for compensation element if stock sold before
2 yr. / 1 yr. holding period
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
True or False?
1. A nonstatutory stock option provides greater tax
deferral than an ISO.
2. An executive must have cash to exercise an
incentive stock option.
3. An executive is not subject to federal income tax on
an ISO when the option is granted or exercised.
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
True or False?
4. The special tax treatment of ISOs are automatic, no
further rules must be met.
5. A granting corporation can never get a tax deduction
for granting an ISO.
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Incentive Stock Options
(ISOs)
Chapter 36
Employee Benefit & Retirement Planning
Discussion Question
Executive I. M. Best is covered under his company’s ISO plan. The
plan grants Best an option in 2007 to purchase company stock for
$150 per share. In February 2009, Best exercises this option and
purchases 100 shares. Fair market value of the 100 shares in
February 2009 is $20,000. Suppose Best sells the 100 shares in
December 2009 for $25,000.
a. What is Best’s taxable gain?
b. How much is treated as compensation income in 2009?
c. How much is treated as capital gain?
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