Incentive stock options (ISOs) give their recipients the option to buy a company’s stock at a specific price and within a specific range of dates. If the price of the company’s stock later rises, the holder of the stock option can use it to purchase stock at below-market prices, which are then sold at the current market price. The stock option holder then pockets the difference. This is not reportable as taxable income to the employee at the time of grant, nor when the employee later exercises the options to buy stock. Once the employee eventually sells the stock, it is taxed as ordinary income; however, if he holds the stock for at least two years, it is taxable as a long-term capital gain. This type of option usually requires the recipient to either exercise or forfeit the option within 90 days of no longer being employed by the issuing company. An ISO is not valid for tax purposes unless it follows these rules:
- Company ownership. Options cannot be granted to a person who owns more than ten percent of all classes of the employer’s stock, unless the maximum option term is restricted to five years and the exercise is at least 110% of the fair market value of the stock.
- Employee only. A company can only issue incentive stock options to its employees, and those individuals must continue to be employed by the company until 90 days before the exercise date.
- Maximum exercised. The maximum aggregate fair market value of stock bought through an ISO exercise cannot exceed $100,000 in a calendar year. Any amount exercised in excess of $100,000 is treated as a nonqualified stock option.
- Maximum term. The maximum term of a stock option is ten years.
- Transfers. Options cannot be transferred by the recipient and they must be exercised during that person’s lifetime.
If an employee acquires stock through an incentive stock option and is willing to hold the stock for at least two years, he can realize a significant tax savings by paying taxes at the long-term capital gains rate. However, waiting two years also presents the risk that the fair market value of the stock will decline, thereby offsetting any savings from paying at the lower tax rate. The IRS has created the Section 83(b) election to mitigate this risk. Under Section 83(b), a stock option recipient can recognize ordinary taxable income on the difference between the purchase price of the stock and its fair market value within 30 days of the option exercise date. When the employee sells the stock at a later date, any subsequent incremental gains are taxed at the long-term capital gains rate.
A major danger to the recipient of a stock option under an incentive stock option plan is the alternative minimum tax (AMT). The AMT is a separate calculation of the income tax that an individual owes, which is intended to keep certain high-income individuals from avoiding paying income taxes. If the AMT is higher than a person’s normal income tax liability, they pay the AMT instead. The AMT requires an employee to calculate a tax liability for the difference between the exercise price of a stock option and the fair market value of the stock on the exercise date. If the AMT then applies to the employee, the employee may be forced to sell the shares at once in order to pay his tax bill. If an employee chooses to hold the stock instead, and the value of the stock later declines, the employee is still liable for the AMT tax that was based on the higher stock price. Thus, the net effect of the AMT is that a judicious employee usually sells his stock immediately, rather than risk a decline in the price of his stock holdings that could yield fewer funds with which to pay the AMT.