Incentive Stock Options (ISOs) in the United States: How Do They Work?

Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs) both give recipients the right to purchase company shares at a predetermined price. However, they differ significantly in tax treatment, eligibility, and reporting obligations under U.S. law.

What are Incentive Stock Options (ISOs)? 

Incentive Stock Options (ISOs) are a type of stock option that U.S. companies can offer to their employees under Section 422 of the Internal Revenue Code. 

ISOs are designed to give employees the chance to buy company stock at a pre-determined exercise price. They offer tax benefits if certain conditions holding requirements are met.

Features of ISOs:

1. Who can receive ISOs: Only employees can receive ISOs. Contractors, advisors, or board members are not eligible.

2. Exercise price: The price employees pay to buy shares must be at least equal to the Fair Market Value (FMV) on the grant date.

3. Holding period requirement: To get the tax benefits, employees must hold the shares for at least two years from the grant date and one year from the exercise date before selling them.

4. Tax treatment: ISOs aren’t taxed as regular income when exercised, but employees may face an Alternative Minimum Tax (AMT). If the shares are held long enough, the sale could qualify for long-term capital gains tax instead of ordinary income tax.

5. ISO cap per employee: Employees can receive up to $100,000 worth of ISOs that vest in a single year, based on the Fair Market Value (FMV) at the grant date. Any amount above this limit is treated as NSOs (Non-Qualified Stock Options).

6. Expiration: ISOs are valid for up to 10 years from the grant date, but if an employee leaves the company, a "post-termination exercise period" (PTE) may shorten the time to exercise the options. To maintain favorable tax treatment, ISOs must be exercised within three months of leaving; otherwise, they are reclassified as NSOs and taxed as such.

7. Reporting requirement: Employers must file IRA form 3921 when employees exercise ISOs and provide the form to employees.

How Incentive Stock Options (ISOs) work for employers?

Incentive Stock Options (ISOs) are granted to employees as part of their compensation package and here's how they work:

1. Granting the ISOs

When an employee is granted ISOs, the company sets an exercise price, typically the fair market value (FMV) of the stock at the time of the grant. The employee can buy shares at this price, even if the stock's value rises later.

2. Vesting period

ISOs typically have a vesting period, meaning employees don’t immediately own the options. They have to work for the company for a certain period (often 3-4 years) before they can exercise their options. 

For example, if you have a 4-year vesting schedule, the options might vest over time, with a portion becoming available each year.

3. Exercising the ISOs

Once vested, employees can exercise their options, meaning they can purchase shares at the exercise price. For example, if the exercise price is $10 and the stock is now worth $50, the employee can buy the shares at the lower price of $10, even though they are worth more on the market.

4. Holding the shares

To qualify for the tax benefits of ISOs, employees must hold the shares for:

- At least 1 year after exercising,

- And at least 2 years from the date the ISOs were granted.

Unlike NSOs, ISOs aren’t taxed at exercise. If the holding periods are met, the sale of the shares is considered a qualifying disposition, and the employee is eligible for long-term capital gains tax on the difference between the exercise price and the sale price.

However, if the holding periods are not met, the sale becomes a disqualifying disposition and ISOs are taxed like NSOs.

5. Disqualifying disposition

In this case, the employee will need to pay ordinary income tax on the difference between the exercise price and the stock’s market price at the time of exercise.

Any further profits from the sale of shares are taxed as capital gains, depending on how long the shares are held after the exercise date.

In a disqualifying disposition, employees face higher taxes.

ISO vs. NSO: What’s the difference?

Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs) differ in important ways, especially when it comes to taxation, eligibility, and their impact on the company and the recipient:

1. Who is eligible for ISOs and NSOs?

- ISOs can only be granted to employees. Contractors, advisors, and board members are not eligible.

- NSOs, on the other hand, can be granted to anyone, including employees, contractors, and advisors.

2. How are ISOs and NSOs taxed?

ISOs:

a. No tax at exercise: Employees don’t pay income tax when they exercise ISOs, but they may be subject to Alternative Minimum Tax (AMT).

b. Taxed at sale: If the holding requirements are met, the sale of the stock is subject to long-term capital gains tax rates, which are typically lower than the ordinary income tax rates that would otherwise apply.

If the holding period requirements are not met, ISOs are taxed like NSOs, both at the time of exercise and upon sale.

NSOs:

a. Taxed at exercise: The difference between the exercise price and the market value of the stock at the time of exercise is considered ordinary income and taxed accordingly.

b. Taxed at sale: When the shares are later sold, any additional gain is taxed as capital gains depending on the holding period from the date of exercise.

3. What’s the exercise price and cap for ISOs and NSOs?

ISOs: They must be granted with an exercise price that is equal to or greater than the fair market value (FMV) of the stock at the time of grant. Additionally, the value of ISOs that can vest in a single year is capped at $100,000 (based on FMV at grant).

NSOs: There is no limit on the total value of NSOs that can be granted to an individual, and the exercise price doesn’t need to meet FMV, although companies typically set it at FMV to avoid tax complications.

5. What’s the expiration period for ISOs and NSOs?

ISOs have a maximum validity of 10 years from the grant date. 

However, when an employee leaves the company, a “post-termination exercise period” (PTE) may apply, which can limit the time available to exercise the options. If the employee does not exercise the options within this window, they will lapse. 

Importantly, even if a longer PTE is allowed under the option plan, ISOs must be exercised within three months of leaving the company to retain their favorable tax treatment.

Otherwise, they are reclassified as NSOs and taxed accordingly. 

In contrast, NSOs do not have a set expiration period unless specified in the company’s option plan. As with ISOs, employees who leave the company are typically given a defined period to exercise any vested NSOs. If they fail to do so within that time frame, the options will lapse.

Conclusion

ISOs offer tax benefits for employees, especially if certain holding periods are met, but they come with stricter rules and limited eligibility. On the other hand, NSOs offer more flexibility in terms of who can receive them and are simpler for companies to manage, though they come with immediate tax implications for employees.