U.S. Company Incentive Stock Options Introduction
- What is equity compensation?
Equity compensation is a form of noncash pay that offers employees ownership in the company they work for. In the U.S., Equity compensation can be used by both public and private companies, and is especially common in start-up companies.
- Types of equity compensation
Equity compensation comes in different forms. The most common types are listed below:
(1) Nonqualified Stock Options (NQSO)
(2) Incentive Stock Options (ISO)
(3) Employee Stock Purchase Plan (ESPP)
(4) Restricted Stock Units (RSU)
(5) Restricted Stock (RS)
This article will be discussed Incentive Stock Options in detail.
- Incentive stock options introduction
(1)
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What is Incentive stock options (ISO)?
Incentive stock options (ISO) are usually granted to a key employee and is a right to purchase stock at a discount.
ISO typically receive a more favorable tax treatment. ISO are only taxed when the shares of purchased stock have actually been sold.
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(2)
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Requirements of ISO
Several requirements must be met in order to qualify as an ISO:
(a) The ISO must be granted under a plan, approved by the shareholders, that sets out the total number of shares that may be issued and who may receive them.
(b) The options must be granted within 10 years of the earlier of the date when the plan was adopted or approved. The options must be exercisable within 10 years of the grant date.
(c) The exercise price may not be less than the Fair Market Value (FMV) of the stock at the date of the grant.
(d) The employee may not own more than 10 percent of the combined voting power of the corporation, parent, or subsidiary as of the date of the grant.
(e) Once exercised, the stock must be held at least two years after the grant date and at least one year after the exercise date.
(f) The employee must remain an employee of the corporation from the date the option is granted until three months (one year if due to permanent and total disability) before the option is exercised.
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(3)
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Employee taxation of ISO
The advantage of an ISO is you do not have to report income when you receive a stock option grant or when you exercise that option.
However，you need to report the taxable income with the alternative minimum tax (AMT) calculation in spreads when you sell the ISO. The spreads are the excess of the FMV of shock on the exercise date less the exercise price plus any amount paid for the option (if any).
For example, if you exercise 1,000 shares at $1 each when they’re worth $5 each, you need to add $4,000 to your income tax return when calculating the spreads.
It is important to note that not all subsequent sales of stock purchased through an ISO are qualified. To be considered a “qualified disposition? and ultimately qualify for favorable tax treatment, the following must be both met:
(a) The employee must sell their shares at least one year after exercising the stock.
(b) The employee must sell their shares two years after the stock was granted.
If the above conditions are not met, any income is an ordinary income and needs to be declared for income tax.
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(4)
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Employer taxation
Generally, an employer does not receive a tax deduction for an ISO because it is not considered compensation income to the employee. This also means that no tax will be withheld by the employer on any income related to the ISO.
Once an ISO has been exercised, the employer will, however, issue Form 3921 to the employee at the end of the tax year. This Form will be used by the employee when the employee completes their personal tax return.
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