Understanding Your Incentive Stock Options

[Kurt Leigh]

If you receive stock options as part of your employee compensation
package then you are one of the lucky ones. This article is intended
to shine a little light on how one of these options, incentive stock
options, works from an employer incentive standpoint and how they
function for tax purposes.
The fact that you are receiving stock options is a testament to your
value as an employee. Management realizes that competent people are
critical to the success of any organization. For public companies,
stock options are a way to motivate employee behavior, while at the
same time anchoring good employees to the company by virtue of placing
certain vesting requirements or restrictions on the exercise of the
stock options.
How valuable are stock options? Let me give you an example that, to
this day, is still fresh in my memory. When I was just starting out my
career and working for a large international accounting firm, I was
put on assignment for a project with a large, publicly-held
pharmaceutical company. I was into my sixth month on the project and I
remember it was a Friday and there was an unusual congenial buzz about
the facility, much more than the typical Friday in the summer in New
Jersey.
I began to ask around as to the source of this congeniality and soon
found out that some stock option vesting window opened (vesting is a
restriction on an employee's ability to exercise stock options) and
because the stock price had been flying high at that moment, there
were many individuals who were about to make a lot of money by
exercising their stock options (purchasing the stock) and selling
their newly acquired shares.
Well, the weekend passed uneventfully for me, but on that Monday, when
I made my way into the parking lot of my big client, I noticed
something very different. It appeared to me as if the parking lot had,
over the weekend, transformed itself into a new car dealership -- BMWs
here, Mercedes' there. It seemed surreal to me, all these new cars
magically appearing over the weekend. It quickly dawned on me that,
indeed, there had been some spending of those stock options over the
weekend. This disproportionate distribution of wealth is what stock
options are all about. The American Dream of "overnight" wealth.
Companies that grant stock options to employees refer to such grants
as Compensatory Stock Options. These are broken down into two
categories: Incentive Stock Options ("ISO", the subject of this
article) and Nonqualified Stock Options. Most employees receive
incentive stock options. Nonqualified stock options are usually
earmarked for senior executives or non-employees that the company
feels are critical to the management of the company's business.
ISOs give the employee the right to purchase the company's stock
(called "exercising" the stock option) at a fixed price (called the
"exercise price"), for a period of time not to exceed ten years from
the date the options are granted to the employee (called "grant
date"). The employee can only exercise the ISO as long as they are an
employee of the company or within twelve months after termination of
employment. There is no taxation to the employee when they receive
their ISOs. Even better, there is no regular income tax when the
employee exercises the stock option (buys the stock). Taxation occurs
in two instances:
1. When the employee exercises the stock option (purchases the stock)
there is no regular income taxation, but there may be an alternative
minimum tax on the excess of the fair market value of the stock on the
exercise date over the employee's exercise price (discounted purchase
price of the stock).
2. When the employee exercises the stock option (purchases the stock)
and subsequently sells the stock there is taxation. Here is where ISO
taxation gets complicated. When you buy your company stock (exercise
the stock option) and sell the company stock the taxable amount is
determined based on when you sold the stock. You can purchase the
company stock (exercise the ISO) and sell the stock in the same year
(called a disqualified disposition) or you can purchase the company
stock and sell the stock in a subsequent year. When you sell the
company stock in a subsequent year the regular tax treatment depends
upon how long you held the stock and how long you held the stock
options.
*Buy and Sell the company stock in same year or within twelve months.
You may have both W-2 income and short term capital gain income as
follows:
- W-2 Income is equal to either A or B below, whichever is the lower
amount:
(A) The fair market value of the employer stock on the exercise date
(date you purchased stock) over the exercise price (discounted
purchase price) or
(B) The sales proceeds on the sale of the company stock over the
exercise price (discounted purchase price) and
- Short-Term Capital Gain Income is equal to the excess of the sales
proceeds on the sale of the company stock over the fair market value
of the company stock on the exercise date (date of purchase).
* Buy company stock in one year and sell it in the next year. If you
hold the stock for more than twelve months (and you held the ISO for
more than two years), then the difference between the sales price and
the exercise price is a long term capital gain which is subject to a
maximum 15% federal tax rate. If you hold the stock for twelve months
or less than the tax calculation is the same as if you had bought and
sold the stock in the same year (W-2 income and possibly short-term
capital gain income).
ISO Example: Stan Smith is an employee of Savurlife Pharmaceutical
Inc. and is given ISOs on January 1, 2004 that entitle him to purchase
(exercise) 100 shares of Savurlife at $1,000 (exercise price) on
January 2, 2006 (exercise date/purchase date). The fair market value
on January 2, 2006 is $3,000. If Stan does not sell the stock in 2006,
then $2,000 ($3,000 less $1,000) will be subject to alternative
minimum tax in 2006, but not subject to any regular income tax in
2006. If Stan sells the stock in 2006 for $3,000 then the $2,000 will
be treated as W-2 wages in 2006. If Stan sells the stock on January 3,
2007 (one year and one day after purchase and ISO held more than two
years) for $3,000 then the $2,000 gain will be treated as a long-term
capital gain and taxed at no more than the maximum capital gains
federal tax rate of 15%.
Employers will grant ISOs to employees but place certain restrictions
on an employee's ability to exercise the ISOs. This is done, in part,
to provide a means of preventing employees from seeking employment
elsewhere. Employers use "vesting" (a typical restriction placed on
the employee's ability to exercise an ISO that may be tied to some
vesting date) as a means of motivating the employee to stay with the
employer. ISOs are typically granted annually and may be tied to some
specific goal achieved by the employee or an overall goal (i.e.
earnings target) achieved by the company. Over time these ISOs can
become a substantial incentive to stay with the employer. If you find
yourself the lucky recipient of an ISO, bide your time, work hard, and
wait for that ISO Friday to cash in on the American Dream.

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