Many of our clients inquire about providing employees with stock options. A stock "option" is the right of an individual to purchase stock from a corporation at a stated price. The option is a written promise to the employee, and states the conditions which must be met in order for the employee to purchase the stock, including the option's expiration date.
An incentive stock option is an option granted under a plan, if the terms of the option and the plan meet certain Code requirements. By paying the exercise price, the employee acquires the optioned stock. An ISO may have an exercise price of no less than 100% of the stock's value at the date of grant of the option, but of course the stock may appreciate in value after the date of grant. If it does, the employee will be able to acquire stock by paying the lower exercise price rather than its current value.
In addition to the chance for a bargain purchase, employees obtain preferential tax treatment upon exercise of their ISOs. Without such treatment, the employees would pay taxes when the options were exercised, on the amount of the "spread" between the stock's value and the exercise price actually paid by the employee. With preferential tax treatment, the employee does not pay taxes until the stock is sold or otherwise disposed of, which may be several years after the taxable year in which the option is exercised. If you would like additional information as to the tax aspects of ISOs (including the employer's deduction), please let me know.
The Tax Code imposes several qualification requirements for treatment as an ISO. Options that do not meet these requirements will not qualify for preferential tax treatment.
ISOs can be useful means of deferring compensation to employees, both to retain key employees, to get better tax treatment while providing this employee benefit, and to transfer a business to one or more key employees over time. However, other forms of deferred compensation, such as retirement plans or phantom stock are also part of our toolbox. These will be discussed in future newsletters.