Incentive stock options: Overview, definition, and example
What are incentive stock options?
Incentive stock options (ISOs) are a type of employee stock option that allows employees to purchase shares of their employer’s stock at a predetermined price (the exercise price) for a certain period of time. ISOs are typically granted as part of an employee’s compensation package and provide potential tax advantages compared to non-qualified stock options (NQSOs). To qualify for these tax benefits, ISOs must meet specific requirements set by the IRS, including holding the stock for a certain period before selling.
For example, an employee might be granted the option to purchase 1,000 shares of company stock at $10 per share, even if the market price of the stock has increased. If the stock’s price rises to $20 per share, the employee can exercise their option to buy the shares at the lower $10 price, potentially realizing a profit.
Why are incentive stock options important?
Incentive stock options are important because they offer employees a way to benefit from the company’s success by purchasing stock at a discount, potentially leading to significant financial gains if the company’s stock price increases over time. ISOs also provide tax advantages, as they may allow employees to avoid paying taxes on the option gains at the time of exercise, instead benefiting from long-term capital gains treatment if the stock is held for at least one year after exercise and two years after the grant date.
For employers, ISOs are an effective tool for attracting, retaining, and motivating employees, particularly in competitive industries. By tying employees’ financial interests to the performance of the company’s stock, ISOs encourage long-term commitment and alignment with company goals.
Understanding incentive stock options through an example
Imagine a startup company grants its key employee 5,000 incentive stock options at an exercise price of $15 per share. Two years later, the company’s stock price increases to $40 per share. The employee can exercise the options and purchase the stock at the original $15 per share price, then either hold the stock for potential future gains or sell it for a profit. If the employee holds the stock for at least one year after exercising the options and two years after the grant date, they may qualify for favorable tax treatment, paying long-term capital gains tax on the profit rather than ordinary income tax.
In another example, an employee of a publicly traded company is granted 1,000 ISOs with an exercise price of $30 per share. Over time, the stock price rises to $50 per share. The employee exercises their options and buys the stock at $30, immediately realizing a $20 per share profit. If the employee holds the shares for the required holding period, they may pay long-term capital gains tax on the profit rather than the higher ordinary income tax rate.
An example of an incentive stock options clause
Here’s how an incentive stock options clause might look in an employment contract:
“The Company hereby grants the Employee the right to purchase [number of shares] shares of common stock at an exercise price of $[exercise price] per share, pursuant to the terms of the Company’s Incentive Stock Option Plan. The options shall vest in accordance with the vesting schedule set forth in [Section X] of this agreement, and the Employee must exercise the options within [X] years of the grant date to qualify for the tax benefits associated with incentive stock options.”
Conclusion
Incentive stock options are a valuable form of compensation that can benefit both employees and employers. For employees, they provide the opportunity to purchase company stock at a discount, with potential tax advantages if the stock is held for the required time. For employers, offering ISOs can help retain talent and align employees' interests with company performance. By structuring stock option plans carefully and complying with IRS requirements, companies can offer ISOs as a powerful tool for employee motivation and retention.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.