1. What to know about Incentive Stock Options
2. How are ISOs Taxed?
3. Characteristics of ISOs
4. Non-Statutory Options Taxation Versus Incentive Stock Options Taxation

What is an incentive stock option? A regular stock option is the right to buy a number of stock shares at a predetermined cost. Stock options fall under two categories — nonqualified stock options (NSOs) and incentive stock options (ISOs). Tax laws treat each of these stock options differently. In most tax scenarios, ISOs are the more favorable option.

What to know about Incentive Stock Options

Incentive stock options are employer-granted and give the employee an option to buy stock in the corporation, a subsidiary, or a parent company at an established price, known as the strike price or exercise price.

Purchasing at the strike price happens when options are available to vest or excise. The strike price is typically set during the granting process; however, options usually vest over a period of time. If a stock's value increases, the ISO gives employees the opportunity to purchase more stock in the future, but at the locked-in strike price from earlier. The difference here is what's called the spread.

How are ISOs Taxed?

The reason ISOs are more favorable from a taxation standpoint is that you purchase them at a predetermined price, which might be significantly lower than market value.

The method of taxation varies based on the disposing of the stock. The term disposed refers to when an employee sells off the stock. It can also refer to transferring the stock to another party or even giving it to charity.

Incentive stock options have two ways of being taxed — on the spread as well as any value increase or decrease on the stock when it's sold, transferred, or disposed in some fashion. To calculate ISO taxes, you'll need to clarify several details:

  • Grant date (incentive stock options grant date)
  • Strike price (the purchase price of the stock)
  • Exercise date (purchase date of stock)
  • Selling price (gross amount received from sale)
  • Selling date (liquidation date of stocks)

Employers are not required to withhold any taxes on the purchase or sale of ISOs. This means people who have purchased ISOs which are not sold at the end of the year might have alternative minimum tax liabilities. An employee who sells their incentive share options could wind up with hefty tax liabilities that weren't paid through any withholdings. It's best if employees send in estimated tax filings and payments to avoid a payment due on their annual tax return. Another option is to increase your withholdings rather than pay estimated payments.

Characteristics of ISOs

There are several key characteristics of incentive stock options. One of these is schedule. Incentive stock options have two important dates; the grant date, making the stock available for purchase, and the exercise date on which the employee exercises the right to buy the stock. There is also a vesting schedule to meet before an employee exercising the stock options. The schedule can vary, but the three-year cliff schedule is sometimes utilized. This means an employee is fully-vested after three years.

Exercising ISOs can happen in one of several ways. This can include paying cash up front to purchase them or using a stock swap (cashless transaction) to purchase. You might hear the term “clawback provision,” which is a set of conditions wherein the employer must recall the stock options. These conditions may relate to an employee's departure for any reason other than disability, death, or retirement, or if the company becomes insolvent and cannot commit to the options.

Non-Statutory Options Taxation Versus Incentive Stock Options Taxation

There are no tax consequences on nonstatutory options, even at the grant or vesting. The rules for exercising ISOs are quite different from non-statutory options. Any employee who exercises a non-statutory stock option has to report the bargain element as earned income because it's subject to withholding tax. Bargain is the term given for a price below the current market price, which provides immediate profits for the employee. ISO holders don't report anything here, it is only done once he or she sells the stock. If the sale falls under a qualifying transaction, the employee only has to report a long-term or short-term capital gain. If the sale falls under a disqualifying disposition, the employee must report any bargain element from the purchase as earned income.

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