What is an Incentive Stock Option (ISO)?
Incentive stock option (ISO) is a type of company stock option granted exclusively to employees. It gives the employee the right, but not the obligation, to purchase shares of a company, usually the option holder's employer, for a fixed price by a certain date. Incentive stock options also confer an income tax benefit when exercised.
Incentive stock options are also commonly referred to as "incentive share options" or "qualified stock options."
How Do Incentive Stock Options (ISOs) Work?
There are two primary kinds of employee stock options: nonqualified options (NQOs) and incentive stock options (ISOs).
Holders of ISOs generally don't pay taxes when they exercise their options; instead, they pay capital gains tax on the difference between the exercise price and the price at which they eventually sell their stock.
Employees receive a tax benefit upon exercise of an ISO because the individual does not have to pay ordinary income tax on the difference between the strike price and the fair market value of the issued shares. Instead -- if the shares are held for 1 year from the date of exercise and 2 years from the date of the grant -- the employee pays taxes at the long-term capital gains tax rate (which is usually lower than the ordinary income tax rate).
ISOs usually have a strike price set at or near the stock's market price on the date of issuance. But ISOs cannot be exercised until several years in the future and usually expire ten years after issuance or upon termination, whichever comes first.
Example of Incentive Stock Options (ISOs)
Let's assume shares of Company ABC currently trade at $10. Company ABC creates an incentive plan for its employees by awarding ISOs with a $15 strike price. If the stock price is $20 a few years later, each employee who was granted ISOs could make a $5 profit upon exercising each of the underlying shares represented by their vested options.
Although ISOs have more favorable tax treatment than non-statutory stock options (NSOs), they require the shareholder to hold on to them for a longer period of time in order to receive optimal tax treatment, increasing the overall risk of the options.
Why Do Incentive Stock Options Matter?
Option grants are incentive compensation that encourages employees to focus on doing work that increases the stock price and thus shareholder value, which is the primary objective of all businesses. A company's board of directors normally must approve option grants. The value of these options is derived from the price of the employer's stock.
Incentive stock options became a popular form of equity compensation because of their tax advantages. There is no income to report when the option is exercised and, if you hold the stock long enough, your gain on its sale is treated as a long-term capital gain.
There are arguments for and against the use of ISOs. The primary argument in their favor is that they align the interests of employees and management with shareholders by giving them an incentive to grow the company. Others argue that incentive options encourage risky behavior by managers since common shareholders bear all of the downside risk whereas managers theoretically only have upside potential.