Incentive Stock Options or ISO

Reward Valuable Executives

A particularly effective method for corporations to reward valuable executives is by creating Incentive Stock Options. These options are similar to the now defunct qualified stock options, but some of the more onerous restrictions have been deleted.

The major advantage of the Incentive Stock Option (ISO) is the favorable tax treatment granted the executive. Such favorable treatment should be useful in attracting and keeping executives as “Golden Handcuffs.” If all the requirements for ISO treatment are fulfilled, the executive pays no taxes either at the time of the grant or upon the exercise of the ISO.

Currently, all “non-qualified” stock options are taxed at ordinary income rates on the difference between the option price and the market price at the date of exercise.

However, for taxable years beginning after 1982, the amount by which the fair market value of a share of stock granted under an ISO at the time of exercise exceeds the option price is an item of tax preference. This affects the calculation of the Alternative Minimum Tax. Moreover, the executive will now have ten years from the date of grant in which to exercise the ISO.

Provided the stock is held for at least one year from the date of exercise and two years from the date of grant, any gain realized on the sale of such stock is taxed as a capital gain.

The granting of ISOs are, however, more costly to the employer than a “non-qualified” stock option. Because the executive has no ordinary income on the exercise of the ISO, the corporation loses the corresponding business deduction. However, it is likely that most corporations will be willing to forego this deduction to attract and keep their most valuable executives. To receive the special treatment given Incentive Stock Options, certain requirements must be met:

• The option plan must have shareholder approval

• Option must be granted within 10 years of date adopted

Or it must be granted within 10 years of the date the plan is approved by the shareholders, whichever is earlier.

• The term of the option may not exceed 10 years

• Option price must be at least equal to fair market value

This refers to the fair market value at the date of grant.

• The option may not be transferable, except at death

• Executives cannot own over 10% of stock voting power

It is generally true that executives may not own more than 10 percent of the voting power of all classes of stock of the employer corporation before the grant.

• ISOs granted pre-1987 must be exercised consecutively

All such incentive stock options held by the executive and granted pre-1987 must be exercised 100% on a first-in, first-out basis. ISOs granted in 1987 and thereafter, however, are not required to be exercised on this basis.

• Maximum value of stock may not exceed $100,000 annually

The Incentive Stock Option provides a corporation with the means to compensate valuable executives without large cash expenditures. Particularly in growth corporations, such as the high technology industries that require substantial cash flows in the initial years, the Incentive Stock Option allows the executive to purchase stock that may multiply rapidly in values as the corporation prospers.

However, the technique of exercising one option by tendering shares acquired through a previous option (known as “pyramiding”) that was expressly approved for non-qualified options, is prohibited with regard to Incentive Stock Options by the 1982 Technical Corrections Act.

In 1984 this ruling was revised, and pyramiding is now approved as long as the company’s plan provides approval. Extreme caution should be exercised when pyramiding to exercise ISO’s. Depending on how the stock being used to pyramid was acquired, adverse tax consequences may occur. It is strongly recommended that you seek guidance from your CPA prior to exercising ISO’s.