This article is the third in our series on equity-based compensation intended to assist employers with answering a common question: What type of equity compensation award is best for our company and our employees? The first article is available here and the second article is available here.

This article will provide an overview of incentive stock options (ISOs). As an overview, this article will address only certain key aspects of ISOs. It is not intended to be a comprehensive discussion of every issue or consideration that applies to these types of awards. The article focuses on privately-held companies and does not address the additional or different securities law, accounting, and governance considerations that apply to publicly-traded companies. In addition, all discussion of taxes is limited to U.S. Federal income tax.

Description

What is an ISO?

ISOs are a type of tax-favored stock option (see “Tax Treatment” below) offered to employees as a means of attracting, retaining, and rewarding employees. ISOs are often granted by employers to employees because they help to align the employee’s interests with those of the employer’s shareholders (see “Advantages” below) by allowing ISO recipients to purchase shares in their employer.

How does a stock option qualify as an ISO?

To qualify as an ISO, a stock option must satisfy the requirements under Internal Revenue Code Section 422 and the applicable regulations. These requirements include, but are not limited to, the following:

• The option must be granted to an employee of the corporation granting the option (or certain related corporations). Non-employee service providers, such as independent contractors, non-employee board members, or consultants, are not eligible for ISOs.
• The option must be granted under a formal written plan document that is approved by the shareholders of the granting corporation within 12 months before or after the date the plan is adopted by the corporation.
• The written plan document under which the ISO is granted must specify (i) the maximum aggregate number of shares that may be issued as ISOs; and (ii) the class of employees who are eligible to receive ISOs. For the second requirement, a statement that ISOs may be granted to any employee of the corporation (or certain related corporations) is compliant.
• The option must be granted within ten years from the earlier of (i) the date the plan was adopted; or (ii) the date the plan was approved by the shareholders.
• The exercise price, which is the price the option holder must pay to buy a share of stock under the option, must not be less than the fair market value of the underlying shares on the grant date for employees (110% of the fair market value for employees who are 10% shareholders).
• The terms of the option must provide that the option is exercisable only by the employee during the employee’s lifetime and prohibit the transfer of the option by the employee, other than by will or the laws of descent and distribution.

Can ISOs be subject to a vesting schedule?

Yes, ISOs are often subject to a vesting schedule during which the employee must remain employed for the ISO to become exercisable. (As a reminder, the term “exercise” in the context of a stock option refers to the option holder’s ability to purchase the shares underlying the option.) Vesting schedules often range from three to five years in total, with some form of ratable vesting over the entire service period. The vesting schedule selected will typically reflect a balance between the employer’s desire to maintain a longer-term retention incentive and the need to ensure that the service provider perceives the vesting schedule as achievable.

When can an employee exercise an ISO?

An ISO must be exercised by the employee within ten years after the date the option was granted (or five years after the option was granted to an employee who is a 10% shareholder). If the option holder terminates employment, the ISO must be exercised on an earlier date (see “Can an employee exercise an ISO after he or she terminates employment?” below).

Can an employee exercise an ISO after he or she terminates employment?

If the option holder’s employment terminates (voluntarily or involuntarily), the option holder has a limited period of time to exercise the ISO and retain the favorable ISO tax treatment described below. To retain the favorable tax treatment, the option holder must exercise the ISO no later than three months after the employee’s termination date, or in the case of a termination due to permanent and total disability, no later than one year after the employee’s termination date. The ISO may remain exercisable beyond those periods, but if the option holder exercises the option beyond the three-month or one-year period, as applicable, the option is subject to tax treatment as a nonqualified stock option (NQSO).

Tax Treatment

Unlike NQSOs, ISOs are not treated as wages when the employee exercises the ISO if the aggregate fair market value (determined as of the grant date) of the shares underlying the ISOs that become exercisable for the first time in any calendar year is $100,000 or less. Any portion of the option that exceeds the $100,000 per year vesting limitation is treated as an NQSO and is subject to ordinary income taxes. As an example, assume a corporation grants an employee an ISO covering shares of stock worth $400,000, as determined at the date of the grant. If the ISO vests at the rate of one-fourth in the calendar year of the grant and each of the next three calendar years, the $100,000 per year vesting limitation would be met.

For example, assume an employee receives an option to buy ten shares of stock with an exercise price of $1 per share. When the employee exercises the option, a share of stock is worth $100 per share. So, the employee only has to pay $10 to purchase stock worth $1,000. The difference of $990 (the “option spread”) is not considered taxable wages. As a result, there is withholding or FICA taxes due on the $990, and the employer does not report the $990 in the employee’s Form W-2, box 1 as wages. Instead, the employer reports the value of the exercised ISOs on Form 3921. Also, because the option spread is not treated as wages, the employer does not get the benefit of a tax deduction.

This favorable tax treatment may be lost if the option holder fails to hold the acquired shares for at least two years following the grant date and at least one year following the date of exercise (see “Disqualifying Disposition” below for more information).

Although the option spread is not treated as taxable wages and is otherwise not included in the option holder’s taxable income, that spread may be an item of adjustment for the option holder under the alternative minimum tax (AMT) rules. For ISOs that have a very large option spread, the option holder may find themselves with a surprise tax bill come April of the following year when they file their taxes due to becoming subject to taxation under the AMT rules.

Upon exercise, the option holder generally acquires a basis in the stock purchased equal to the price paid for the shares. When the stock is subsequently sold, any appreciation or decline in value would generally be a short- or long-term capital gain or loss, respectively. Using the same example as above, the employee’s basis in the shares would be $10 and, if the employee later sold them for $1,500, the $1,490 would be capital gains.

Disqualifying Disposition

If an employee sells their ISO shares within one year from the date of exercise or within two years from the grant date (a “disqualifying disposition”), the employee recognizes ordinary income at the time of such sale equal to the excess of the fair market value of the shares on the date of exercise over the aggregate exercise price ($990 in the prior example). Any additional gain upon the sale of the shares will be taxed at short-term or long-term capital gains rate, depending on how long the shares have been held. If the employer reports the taxable ordinary income on the employee’s Form W-2 for the year the disqualifying disposition occurred, then the employer may take a corresponding tax deduction. The employer is not responsible for any tax income, FICA, or FUTA tax withholding for the ordinary income generated as a result of the disqualifying disposition.

Advantages

ISOs have several potential advantages as an incentive compensation vehicle:

• There is a possibility of large gains if the stock value increases significantly, which can be highly motivating to employees and help to align their interests with shareholders.
• Options are generally easy to understand, making it more likely that employees will perceive them as valuable as long as the stock value is believed to be likely to increase.
• The option holder can elect the time of exercise once the ISO is vested and can decide when to recognize capital gain (or loss), if applicable.
• The difference or spread is exempt from ordinary income tax if the employee does not sell the shares purchased under the option for at least two years following the grant date and at least one year following the date of exercise.

Disadvantages

Some potential disadvantages to ISOs include the following:

• Because of the exercise price, ISOs have no value to the option holder unless stock value increases above the exercise price. If the stock does not increase in value, or declines in value, ISOs can quickly lose their motivating power or even become demoralizing if the stock value remains below the exercise price for an extended period.
• Upon exercise, the option holder must pay the exercise price of the ISOs being exercised, which may require borrowing money (see a related article here) or selling shares to finance the option exercise and related taxes (which will impact the tax-favorable ISO treatment).
• To set the exercise price, the employer generally must determine the fair market value of its stock at the time of grant within the framework of Code Section 409A, which can involve incurring additional costs if an independent third-party appraisal is used. A discussion of the Code Section 409A framework for valuing stock is available here. 
• Employees may not achieve the full tax benefit of their ISOs if they do not satisfy the necessary holding period requirements, resulting in a disqualifying disposition, or if the option spread results in taxation under the AMT rules.
• Unlike NQSOs, the employer generally does not receive a tax deduction corresponding to the option spread upon exercise unless there is a disqualifying disposition (see “Disqualifying Disposition” above).

Other Considerations

Securities Laws

ISOs are considered “securities” for purposes of U.S. Federal and state securities laws. Accordingly, their grant and exercise must comply with the requirements of the Securities Act of 1933. The Securities Act generally requires that any time a security is offered and sold, it must either be registered with the Securities and Exchange Commission or qualify for an exemption. 

An exemption frequently used for ISOs in the private company context is known as Rule 701, which generally exempts from registration securities that are offered and sold to employees, consultants, or advisors of the issuer or its subsidiaries under a written compensatory benefit plan if certain requirements are met.

In addition to the U.S. Federal securities laws, any grant of ISOs in the U.S. must qualify for an exemption under, or comply with state “blue sky” laws. The state “blue sky” laws where the employee or consultant resides at the time the ISO is granted will generally apply. Certain states may require a notice filing or payment of a fee when ISOs are granted to service providers in those states. Companies should review the applicable state “blue sky” laws before any ISO grants are made to an employee or consultant in that particular state.

Documentation and Stockholders’ Agreements

ISOs must be documented using a plan that contains the main terms and conditions applicable to the ISOs, with individual award agreements given to each recipient setting forth the particular terms and conditions of their ISO award, such as the number of ISOs granted, the exercise price, and their vesting period. The board of directors of the company normally adopts the plan and approves each grant (after receiving shareholder approval for ISO purposes), although delegation of such authority to an officer may be available.

When ISOs are to be exercised for private-company stock, it is often prudent from the employer’s perspective to require the employee to enter into a stockholders’ agreement or similar agreement that will govern the employee’s ownership of the stock following exercise. A stockholders’ agreement can provide valuable protections for the employer and its other stockholders by, for example, limiting the transfer of stock (often by making it subject to a right of first refusal), ensuring that the employer has the ability to repurchase the stock if the employee leaves employment, and requiring the employer to participate in a merger or other sale transaction that is supported by the other stockholders.

As we noted at the beginning of this article, because the article is intended as an overview, it addresses only certain key aspects of ISOs and does not provide a comprehensive discussion.