If you’re looking for a way to incentivize employee performance in your company without having to hand out hefty salaries and bonuses, you may want to consider incentive stock options (ISOs). Often referred to as qualified (or statutory) stock options, ISOs are a type of employee stock option that provide employees with non-cash compensation in the form of stock options. Today’s post will examine some of the key features of ISOs, as well as the basic requirements to be a qualified ISO.
Tax Benefits of Using ISOs
Perhaps the most significant benefit, especially from the employee’s perspective, of using ISOs is the tax benefit. An employee who exercises the option to purchase stock does not have to pay ordinary income tax on the difference between the exercise price and the fair market value of the stock issued. Instead, as long as the shares are held for 1 year from the date the employee exercises the option and 2 years from the date the option was granted, the profit made on the sale of the stock is taxed as long-term capital gain, which is taxed at significantly lower rates than ordinary income. The (obvious) benefit of this is that you receive favorable tax rates. The (not so obvious) downside is that in order to utilize these favorable tax rates, you (as the employee) are forced to hold onto the stock for a longer period of time, which can be risky in some cases.
Another key distinction of ISOs is that the employer does not claim a corporate income tax deduction when the employee exercises the option, unless the employee does not meet the holding period requirements.
Employees Feel Connected to the Company
In addition to the tax benefits, ISOs offer an easy way for employees to feel more connected to the company they work for. What better way to give your employees incentive to work harder than to give them ownership of the company? Employees who have a stake in the overall performance of the company will take more pride in the work they produce and most likely produce higher quality work.
The Use of ISOs For Emerging Companies
One of the major reasons behind using ISOs is the ability to attract quality talent without having spend large amounts of cash. Many emerging companies simply do not have the cash to spend on hefty salaries and bonuses. However, granting ISOs allows the emerging company to attract talent by offering a stake in the future growth and profits of the young company. At the height of the Internet boom during the 1990s, ISOs were commonly used by emerging companies in place of competitive salaries since many of these start-ups had relatively little cash. Today, however, they’re used less often by emerging companies since many of the start-up Internet companies of the 90s failed to generate any profit and left many key management personnel with worthless stock options. More established companies commonly use ISOs as an added perk in executive compensation packages.
Stock May Be More Valuable Than Cash
Keep in mind that stock is valuable, i.e. it’s not without cost to give away stock. It may not cost the company up-front, like giving away cash would, but it may cost more in the long run if the stock appreciates in value. Under this scenario, the owners of the company would have less because they gave ISOs, essentially a percentage of ownership, to the employees. Depending on how much the stock may increase in value, it may have been cheaper to pay the employees in cash than in ISOs.
Basic Requirements for (Qualified) Incentive Stock Options
In order to take advantage of the tax benefits, your ISO must be qualified. Below is a brief, and very basic, outline of the requirements of qualified stock options. To be qualified:
- The option must be granted only to an employee, who must exercise the option while he or she is still an employee or no later than three months after termination of employment.
- The option must be granted under a written plan document specifying the total number of shares that may be issued and the employees who are eligible to receive the options. The plan must be approved by the shareholders within 12 months before or after plan adoption.
- The ISO must be granted under an ISO agreement, which must be written and must list the restrictions place on exercising the ISO, including an offer to sell the stock at the option price and the period of time during which the option will remain open.
- The ISO must be granted within 10 years of the earlier of adoption or SH approval, and exercisable within 10 years of grant.
- The ISO must have an exercise price that is equal to or exceeds FMV at the time of grant.
- The employee must not, at time of grant, own stock representing more than 10% of voting power of all outstanding shares.
- The ISO agreement must specifically state that ISO cannot be transferred by the option holder other than by will or laws of the descent, and it must only be exercisable by the option holder.
- The aggregate FMV of all ISOs granted to your employees cannot exceed $100,000 in a calendar year. To the extent they do exceed, the IRS treats the options as non-qualified stock options (see Section 422(d)).
The ins and outs of the tax regulations surrounding ISOs are complex and you should always consult a tax lawyer for specific tax-related advice.