If you have been looking for a way to reward your employees for their hard work, you can think of offering them something more than just a salary and medical benefits.
One of the major benefits that companies offer to their employees is the choice to purchase the company shares and become a shareholder of the company. This allows employees to share in the profits of the company, and align their financial interests with the company’s success.
In fact, there are many kinds of stock purchase plans that have such features and are offered to the employees of a company. But out of all the plans to offer equity compensation to your employees, there is one kind of stock option that usually makes the top of the list – incentive stock option (ISO). It is popular in many companies and offered to the key employees and top-tier management. ISOs are qualified or statutory options and can easily receive preferential tax treatment in a lot of cases.
What is an Incentive Stock Option?
ISO, also called incentive stock option, is a kind of employee stock option with some added tax benefits. When an ISO is exercised, there is an option to treat any gain on this sale as taxed at the capital gains rate, rather than the standard ordinary income rate for the option holder.
ISOs are usually offered to employees as an encouragement to stay and work for a longer period of time, where these employees would contribute to the further development and growth of the company. In general, ISOs are offered as added compensation with the current salary or as a bonus to employees instead of a salary raise.
This kind of incentive can be used to easily attract new hires in a company, mostly if the company doesn’t have the money to pay higher salaries. But even though ISOs have a favorable tax treatment, they also come with some negative aspects as well. One of these is that the holder has to take the risk of owning the stock for a long period of time so that they can enjoy a better tax treatment. Moreover, there are a lot of requirements to qualify as an ISO.
Let us understand the ISO in detail, beginning with the important features of the ISO.
Important Features of ISO
ISOs have many important features that make them one of the best plans that companies opt for. Here are the most important incentive stock option features:
- Schedule: ISOs have a schedule for every process. Basically, the ISOs are issued on the grant date. After this, the employee makes their way towards purchasing the options on the exercise date. As soon as the options are exercised, the employee would have the freedom to sell off the stock or wait for a while. The time for which they would have to wait depends on the agreement of the ISOs. In fact, the offering period for the incentive stock options often reaches about 10 years, after which the time for the option expires.
- Vesting: Incentive stock options normally have a vesting schedule that must be satisfied before the employee exercises options. There is a standard 1-3 year cliff schedule, where the employee becomes vested in the options issued to them after that time. Some other employees use the graded vesting schedule that become invested in 1/4th of the options every year, starting from the second year from the grant date. In this case, the employee is completely vested in all the options during the 5th year from the grant date.
- Exercise Method: Incentive stock options, just like non-qualified stock options, can be exercised in various different ways. In short, the employee can either pay cash for exercising the options, it can be a cashless transaction, or can be a stock swap transaction.
- Bargain Element: Incentive stock options can normally be exercised at a price lower than the present market price. And due to this, the employee gets an immediate profit from exercising the ISOs.
- Clawback Provisions: These are the conditions in the ISO deal that permit the employer to recall the options. Basically, recalling can happen if the employee leaves the company for any reason other than death, retirement, disability, or in case the company itself becomes financially unstable and is not able to fulfil the obligations in the options.
- Discrimination: While most of the employee stock plans have to be offered to those employees in a company who meet the specific minimal requirements, ISOs are offered mostly to the key employees and/or executives of the company.
With the understanding of what the important features are, let us understand the taxation process better.
Taxation of ISOs
ISOs have more favorable tax treatment as compared to any of the other employee stock purchase plans. And this is what sets the options apart from the other equity-based compensation.
Nonetheless, it is vital for employees to meet the requirements so that they can take advantage of these tax benefits. To understand better, you need to know that there are two kinds of dispositions for ISOs:
- Qualifying Disposition: The sale of the incentive stock option that is made at least two years after the grant date and one year after it was exercised. In short, both terms have to be met for the sale of the stock to qualify
- Disqualifying Disposition: This is the sale of incentive stock options that do not meet the prescribed holding period requirements.
With this in mind, it is important to note that there are no tax consequences at both the granting and vesting date of the ISOs. Nevertheless, ISO holders would need to report about the stock when it is sold, not before the sale. In case the stock is a qualifying transaction, then the employee would report a long-term or a short-term capital gain on the sale. On the other hand, in case the sale is a disqualifying disposition, the employee would have to report any bargain element from the exercise as earned income.
Reporting and AMT
Even though qualifying ISO dispositions can be reported as long-term capital gains when filing Form 1040, the bargain element at exercise is also a preference item for alternative minimum tax (AMT). Basically, this tax is applied to those people who have a large amount of specific kinds of income, like municipal bond interest or ISO bargain elements.
The AMT is designed to make sure that these taxpayers pay the minimum amount of tax on their income that would have otherwise been tax-free. To obtain your AMT amount, you can find the calculation process on Form 6251. You can also take the help of a tax professional to understand the tax effects for these transactions. These proceeds on the sale of ISO stock has to be reported on form 3921 and carried over to Schedule D on the tax return.
You can get help from a tax professional regarding this or contact Eqvista to know more!
How Incentive Stock Options Are Used?
ISOs are usually given a market value price by the company on the grant date. However, there is normally a specific amount of time the employees need to wait for the options to vest, and before they exercise them into shares at the strike price (lower price than the current market value when they obtain the shares).
The basic idea behind this is that the market value of the shares would increase over time before they are vested. And by this, the employee would be able to purchase the stock at a discount and eventually sell off some of those shares at a premium.
Moreover, the tax rate would change from the time the shares are owned. To better explain with an example, if the shares from the ISOs were sold 2 years after they were granted and 1 year after they were exercised, the capital gains would fall under the long-term capital gains tax treatment. And for the shares that are sold earlier, the gains would be considered as ordinary income. These gains from the ISOs can also be subjected to the AMT.
Why are ISOs so popular?
From all this we can see that incentive stock options are popular due to the tax advantages they have. In short, the ISO holder does not need to report any income when the option is exercised, and in case they hold the stock for a long time, the gain on the sale would be treated as a long-term capital gain. All this is a good profitable situation for the ISO holder.
How Eqvista helps you?
Incentive stock options can provide substantial income to its holders, but the tax rules for their exercise and sale can be complex in some cases. Eqvista has many articles that can help you with the various details about equity tax and related topics.
Moreover, if you are in need for a cap table application to keep a track of all the shares in your company, Eqvista is a great choice for you. It is a FREE cap table application that can help you in managing the shares of your company.
But that is not all. Eqvista would also help you in staying compliant with the equity rules. You can also have your company incorporated and registered through Eqvista. In short, Eqvista is your one-shop-stop for all the entrepreneur needs that you might have. Find out more about what Eqvista can offer you here!