Understanding Your Incentive Stock Options

If you receive stock options as part of your employee compensation package then you are one of the lucky ones. This article is intended to shine a little light on how one of these options, incentive stock options, works from an employer incentive standpoint and how they function for tax purposes.

The fact that you are receiving stock options is a testament to your value as an employee. Management realizes that competent people are critical to the success of any organization. For public companies, stock options are a way to motivate employee behavior, while at the same time anchoring good employees to the company by virtue of placing certain vesting requirements or restrictions on the exercise of the stock options.

How valuable are stock options? Let me give you an example that, to this day, is still fresh in my memory. When I was just starting out my career and working for a large international accounting firm, I was put on assignment for a project with a large, publicly-held pharmaceutical company. I was into my sixth month on the project and I remember it was a Friday and there was an unusual congenial buzz about the facility, much more than the typical Friday in the summer in New Jersey.

I began to ask around as to the source of this congeniality and soon found out that some stock option vesting window opened (vesting is a restriction on an employee's ability to exercise stock options) and because the stock price had been flying high at that moment, there were many individuals who were about to make a lot of money by exercising their stock options (purchasing the stock) and selling their newly acquired shares.

Well, the weekend passed uneventfully for me, but on that Monday, when I made my way into the parking lot of my big client, I noticed something very different. It appeared to me as if the parking lot had, over the weekend, transformed itself into a new car dealership -- BMWs here, Mercedes' there. It seemed surreal to me, all these new cars magically appearing over the weekend. It quickly dawned on me that, indeed, there had been some spending of those stock options over the weekend. This disproportionate distribution of wealth is what stock options are all about. The American Dream of "overnight" wealth.

Companies that grant stock options to employees refer to such grants as Compensatory Stock Options. These are broken down into two categories: Incentive Stock Options ("ISO", the subject of this article) and Nonqualified Stock Options. Most employees receive incentive stock options. Nonqualified stock options are usually earmarked for senior executives or non-employees that the company feels are critical to the management of the company's business.

ISOs give the employee the right to purchase the company's stock (called "exercising" the stock option) at a fixed price (called the "exercise price"), for a period of time not to exceed ten years from the date the options are granted to the employee (called "grant date"). The employee can only exercise the ISO as long as they are an employee of the company or within twelve months after termination of employment. There is no taxation to the employee when they receive their ISOs. Even better, there is no regular income tax when the employee exercises the stock option (buys the stock). Taxation occurs in two instances:

1. When the employee exercises the stock option (purchases the stock) there is no regular income taxation, but there may be an alternative minimum tax on the excess of the fair market value of the stock on the exercise date over the employee's exercise price (discounted purchase price of the stock).

2. When the employee exercises the stock option (purchases the stock) and subsequently sells the stock there is taxation. Here is where ISO taxation gets complicated. When you buy your company stock (exercise the stock option) and sell the company stock the taxable amount is determined based on when you sold the stock. You can purchase the company stock (exercise the ISO) and sell the stock in the same year (called a disqualified disposition) or you can purchase the company stock and sell the stock in a subsequent year. When you sell the company stock in a subsequent year the regular tax treatment depends upon how long you held the stock and how long you held the stock options.

*Buy and Sell the company stock in same year or within twelve months. You may have both W-2 income and short term capital gain income as follows:

- W-2 Income is equal to either A or B below, whichever is the lower amount:

(A) The fair market value of the employer stock on the exercise date (date you purchased stock) over the exercise price (discounted purchase price) or

(B) The sales proceeds on the sale of the company stock over the exercise price (discounted purchase price) and

- Short-Term Capital Gain Income is equal to the excess of the sales proceeds on the sale of the company stock over the fair market value of the company stock on the exercise date (date of purchase).

* Buy company stock in one year and sell it in the next year. If you hold the stock for more than twelve months (and you held the ISO for more than two years), then the difference between the sales price and the exercise price is a long term capital gain which is subject to a maximum 15% federal tax rate. If you hold the stock for twelve months or less than the tax calculation is the same as if you had bought and sold the stock in the same year (W-2 income and possibly short-term capital gain income).

ISO Example: Stan Smith is an employee of Savurlife Pharmaceutical Inc. and is given ISOs on January 1, 2004 that entitle him to purchase (exercise) 100 shares of Savurlife at $1,000 (exercise price) on January 2, 2006 (exercise date/purchase date). The fair market value on January 2, 2006 is $3,000. If Stan does not sell the stock in 2006, then $2,000 ($3,000 less $1,000) will be subject to alternative minimum tax in 2006, but not subject to any regular income tax in 2006. If Stan sells the stock in 2006 for $3,000 then the $2,000 will be treated as W-2 wages in 2006. If Stan sells the stock on January 3, 2007 (one year and one day after purchase and ISO held more than two years) for $3,000 then the $2,000 gain will be treated as a long-term capital gain and taxed at no more than the maximum capital gains federal tax rate of 15%.

Employers will grant ISOs to employees but place certain restrictions on an employee's ability to exercise the ISOs. This is done, in part, to provide a means of preventing employees from seeking employment elsewhere. Employers use "vesting" (a typical restriction placed on the employee's ability to exercise an ISO that may be tied to some vesting date) as a means of motivating the employee to stay with the employer. ISOs are typically granted annually and may be tied to some specific goal achieved by the employee or an overall goal (i.e. earnings target) achieved by the company. Over time these ISOs can become a substantial incentive to stay with the employer. If you find yourself the lucky recipient of an ISO, bide your time, work hard, and wait for that ISO Friday to cash in on the American Dream.

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