Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Incentive Stock Option (ISO)

What it is:

Incentive stock option (ISO) is a type of company stock option granted exclusively to employees. It confers an income tax benefit when exercised. 

How it works (Example):

Incentive Stock Options are also referred to as "incentive share options" or "qualified stock options."

The employee receives 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 issue. But ISOs cannot be exercised until several years in the future and usually expire ten years after issuance or upon termination, whichever comes first. 

Let's suppose that shares of Company A currently trade at $10. Company A creates an incentive for its employees to grow the company and increase the share price by awarding ISOs with a $15 strike price that can be exercised after ten years. If the stock price is $16 ten years later, each employee who was granted ISOs makes a $1 profit upon exercising the option. A person in the 28% marginal income tax bracket will pay taxes at the long-term capital gains rate instead (15% until 2012). 

Although ISOs have more favorable tax treatment than non-statutory stock options (NSOs), they require the stock holder 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 it Matters:

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 incentive stock options. 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 shareholders bear all the downside risk whereas managers theoretically only have upside potential.