Incentive Stock Option (ISO)

A type of compensation given to employees to purchase shares at a fixed price (exercise price) for a given period of time

What is an Incentive Stock Option (ISO)?

An incentive stock option (ISO) is a type of compensation given to employees, usually part of a broader compensation plan. ISOs can only be given to participating employees and can only be granted under defined limits.

 

Incentive Stock Option (ISO)

 

Incentive stock options allow employees to purchase shares at a fixed price (exercise price) for a given period, regardless of the current price in the market. The ISOs will provide value if the actual market price is more than the exercise price. If the actual share price is less than the exercise price, stock options have no value as no one would exercise them.

 

Summary

  • An incentive stock option (ISO) is a type of compensation given to employees to purchase shares at a fixed price (exercise price) for a given period of time.
  • When ISOs are exercised, the stocks are bought at a predefined price, which can be way below the actual market stock price.
  • There are several key dates that employees should know regarding their stock incentive options – grant date, vesting date, and expiration date.

 

Incentive Stock Options and Taxation

Incentive stock options can be exercised in various ways. Employees can pay cash in advance to exercise them, do so in a cashless transaction, or through a stock swap.

When ISOs are exercised, the stocks are bought at a predefined price, which can be way below the actual market stock price. In the case of an incentive stock option, the income does not need to be reported when a stock grant is received or when the option is exercised.

The taxable profits are only reported when stocks are sold. Moreover, based on the time a stock is owned, in the US the profits are taxed at capital gain rates ranging from 0% to 23.8% (for revenue in 2020), usually much lower than the normal income tax rate. The tax rates also depend on the transaction dates, when the stock options are exercised to sell and buy stocks.

The difference between the grant price paid to purchase a stock and its actual market value is called the bargain element. The amount must be reported as taxable compensation for the Alternative Minimum Tax (AMT) purposes in the same year the stock option has been exercised.

 

Incentive Stock Options and Critical Dates

There are several key dates that employees should track regarding their incentive stock options. These dates are important since they determine when the stock options vest, when they can be exercised, and when the employees no longer have the right to execute the options. The following are the key dates that employees monitor:

 

1. Grant date

The grant date for an incentive stock option is the date on which the shares are allocated. The grant date is also the date on which the shares are normally valued and is determined by the exercise price.

The shares of the stock are purchased through the option at a price known as the exercise price. However, the date of the grant is not always the time when the option can be exercised to buy the shares.

 

2. Vesting date

The vesting date is when the ISOs become available to the employees. The number of options that vest depends on the terms of the incentive stock option plan agreement.

Certain plans allow a set date when all of the incentive stock options must be vested, and others let a certain number of shares be distributed over a period of time.

 

3. Expiration date

The expiration date is the final day when employees can exercise their right to purchase their shares at the exercise prices. If the expiration date passes and the options are not exercised, the incentive stock options cease to exist, which can result in a missed opportunity and lost income.

 

More Resources

CFI is the official provider of the Certified Banking & Credit Analyst (CBCA)® certification program, designed to transform anyone into a world-class financial analyst.

To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Capital Gain
  • Early Exercise
  • Taxable Income
  • Employee Stock Ownership Plan (ESOP)

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