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Incentive Stock Options (ISOs)

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Why Do Companies Offer Stock Options? | Finance - Zacks

Measure content performance. Develop and improve products. List of Partners vendors. One of the major benefits that many employers offer to their workers is the ability to buy company stock with some sort of tax advantage or built-in discount. There are several types of stock purchase plans that contain these features, such as non-qualified stock option plans. These plans are usually offered to all employees at a company, from top executives down to the custodial staff.

However, there is another type of stock option , known as an incentive stock option , which is usually only offered to key employees and top-tier management. These options are also commonly known as statutory or qualified options, and they can receive preferential tax treatment in many cases. Incentive stock options are similar to non-statutory options in terms of form and structure.

Schedule: ISOs are issued on a beginning date, known as the grant date, and then the employee exercises their right to buy the options on the exercise date. Once the options are exercised, the employee has the freedom to either sell the stock immediately or wait for a period of time before doing so. Unlike non-statutory options, the offering period for incentive stock options is always 10 years, after which time the options expire. Vesting: ISOs usually contain a vesting schedule that must be satisfied before the employee can exercise the options.

The standard three-year cliff schedule is used in some cases, where the employee becomes fully vested in all of the options issued to them at that time. Other employers use the graded vesting schedule that allows employees to become invested in one-fifth of the options granted each year, starting in the second year from the grant. The employee is then fully vested in all of the options in the sixth year from the grant.

#1: All About ISOs

Exercise Method: Incentive stock options also resemble non-statutory options in that they can be exercised in several different ways. The employee can pay cash up front to exercise them, or they can be exercised in a cashless transaction or by using a stock swap. Bargain Element: ISOs can usually be exercised at a price below the current market price and, thus, provide an immediate profit for the employee.

Clawback Provisions: These are conditions that allow the employer to recall the options, such as if the employee leaves the company for a reason other than death, disability, or retirement, or if the company itself becomes financially unable to meet its obligations with the options.

ISOs can be informally likened to non-qualified retirement plans, which are also typically geared toward those at the top of the corporate structure, as opposed to qualified plans, which must be offered to all employees. ISOs are eligible to receive more favorable tax treatment than any other type of employee stock purchase plan.

This treatment is what sets these options apart from most other forms of share-based compensation.

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However, the employee must meet certain obligations in order to receive the tax benefit. There are two types of dispositions for ISOs:. Just as with non-statutory options, there are no tax consequences at either grant or vesting. However, the tax rules for their exercise differ markedly from non-statutory options. An employee who exercises a non-statutory option must report the bargain element of the transaction as earned income that is subject to withholding tax.

ISO holders will report nothing at this point; no tax reporting of any kind is made until the stock is sold. Exercise your stock options to buy shares of your company stock and then hold the stock. Depending on the type of the option, you may need to deposit cash or borrow on margin using other securities in your Fidelity Account as collateral to pay the option cost, brokerage commissions and any fees and taxes if you are approved for margin. Exercise your stock options to buy shares of your company stock, then sell just enough of the company shares at the same time to cover the stock option cost, taxes, and brokerage commissions and fees.

The proceeds you receive from an exercise-and-sell-to-cover transaction will be shares of stock. You may receive a residual amount in cash. With this transaction, which is only available from Fidelity if your stock option plan is managed by Fidelity, you may exercise your stock option to buy your company stock and sell the acquired shares at the same time without using your own cash. The proceeds you receive from an exercise-and-sell transaction are equal to the fair market value of the stock minus the grant price and required tax withholding and brokerage commission and any fees your gain.

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Tip: Know the expiration date for your stock options. Once they expire, they have no value. When your stock options vest on January 1, you decide to exercise your shares. You sell your shares at the current market value. If you had waited to sell your stock options for more than one year after the stock options were exercised and two years after the grant date, you would pay capital gains, rather than ordinary income, on the difference between grant price and the sale price. If you have stock options in a plan that is administered by Fidelity, you can view, model or exercise options online.

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