Incentive Stock Option (ISO)

What Are Incentive Stock Options (ISOs)?

An incentive, as the name suggests, is a kind of benefit given to an employee. The incentive stock option is also an additional benefit, compensation given to an employee by his employer. It is a unique opportunity for the employees as they can purchase the company’s shares where they work at a discounted price.

The employees can become the company's shareholders and be entitled to a possible tax benefit as the tax will be charged on the capital gains rate in the case of ISOs.

Generally, these stocks are awarded to the higher officials of the company, such as top management and senior position members. Still, even hardworking employees are offered such shares to incentivize them for their work.

The most important reason to offer such shares to employees is to ensure that they stay with the company, contributing to its growth with their hard work and dedication. In addition, this will boost the morale and confidence of other employees to work hard to grab such an opportunity.

Options are a type of compensation in addition to the salaries or a reward used to attract potential employees to work even harder in the future. It is advantageous for employees when the company's stock price increases as they earn a profit on its sale, just like a normal investor.

How Incentive Stock Options (ISOs) Work

The employer offers the share to his employee at a discounted rate, allowing the employee to exercise his right to purchase the share at that rate later in the future.

The date on which ISOs are issued is termed the grant date, and the date on which the employee exercises his right is termed the exercise date.

Before the employee can exercise his option to buy the shares, the options must vest.

Once the options vest and the employee has the right to exercise his option, it is his choice to decide whether he wants to sell the stock at the prevailing market rate or wait for some time before doing so.

Let us understand this with the help of an example- Mr. Raj has granted 1000 ISO shares to an employee named Ria for a discounted price of $10 per share. Now since the options vest after a year, she will have to hold this stock till that time and wait for its sale.

Suppose the stock value has appreciated after a year, and she decides to sell these at the prevailing rate, say it is $20. Ria will now earn a profit of $5($20-$15) on each share. This is termed the capital profit on ISOs.

What to know about Incentive Stock Options?

We need to look at a few terms before we go further into the topic.

There are various terms related to this topic.

1. Grant Date: The ISOs are granted at a defined price and offered to the employee by the company at a predefined date termed the grant date.
2. Vesting Period: Similar to other stock options, ISOs also have a vesting term, which means the waiting time before receiving ownership of the award and has an expiration date.
   Once an ISO vest becomes available to exercise, employees may exercise it at any point before its expiration.
3. Expiration: Similar to stock options, ISOs have an expiry date, after which the employee will not have any right to purchase the shares.
4. One-year cliff: The employer imposes this condition to ensure that the employee stays with the company for at least a year. This means that the vesting period is generally for one year.

The ISOs are the most popular among employees because of the tax benefit it offers. Employees need not pay any tax when they are offered the share or exercise the option. This leads them to enjoy either a capital gain or a capital loss when they sell off their shares.

For example, Joe was awarded an ISO on January 2, 2020, to buy up to 500 shares of XYZ Ltd at $15. XYZ Ltd trades at $17.65, and the option vests in 24 months. So if Joe leaves the company before January 3, 2022, he will get nothing.

Advantages vs. Disadvantages of Incentive Stock Options (ISOs)

Now let us discuss some advantages and disadvantages of ISOs

The advantages are

• Like any stockholder, the issuance of ISO makes an employee the owner of the company’s share.
• The offer of ISO by an employer boosts employees' confidence toward working for the company's growth.
• Employees get tax benefits because they are not supposed to pay any tax on such shares until their sale.
• Unlike other investors who will invest in the company later at a higher market price, the employees are allocated such shares at a much lower rate.

The disadvantages are

• Since the company is offering the shares to its employees, it can affect the company's ownership in the future due to the presence of many shareholders.
• Secondly, the prevailing market price of the stock might lead to uncertainties, such as the stock might hit rock bottom or rising to a new high if the company gives such stocks to many employees.

Taxes on Incentive Stock Options (ISOs)

The ISOs, as compared to other forms of compensation, have better tax treatment since they are used to retain the company's employees. To be eligible for capital gains tax, an employee who has been offered the ISO needs to

• Hold the stock for more than one year from the exercise date 
• Hold the share for more than two years from the time of the grant.

For example, a company offered 100 ISO shares to an employee on December 1, 2019, which can only be bought at the exercise price on December 1, 2021 ( the second condition is satisfied).

To be eligible for capital gains tax, the employee must hold these shares until December 1, 2022, fulfilling the first condition.

Incentive Stock Options (ISOs) vs. Non-Qualified Stock Options (NQSO)

Incentive stock options (ISOs) and non-qualified stock options are the two basic categories of employee stock options (NQSOs). They are types of employee compensation used to attract and retain talented employees. However, there are critical differences between these types of stock options.

ISOs and NSOs have some key differences, which are discussed below-

1. NSOs are a form of employee compensation with an income tax attached to it wherein the employee must pay income tax on the difference between the grant price and the option's exercise price.
2. On the other hand, ISOs have a capital gains tax, making them a better tax treatment choice.
3. ISOs are restricted to only the employees of the company. In contrast, the NSOs can be offered and allocated to contract-based workers, investors, and regular employees. This makes the NSOs easy to use.

Incentive Stock Options (ISOs) vs. Restricted Stock Units (RSUs)

Restricted Stock Units (RSU) is a grant issued to an employee as compensation or to meet performance goals. They are popular with startups as they need to retain their new employees in the initial period only. However, they are restricted because they vest after several years.

RSU has various restrictions: time-bound, milestone-based, and time and milestone-based. In time-based restrictions, RSU unlocks if an employee stays with a company for a predefined period.

In a milestone-based restriction, RSU unlocks if the employee reaches some specified goal. In both time and milestone-based restrictions, the employee must surpass the specified milestone within the given time to get the benefits of RSU.

Some of the main differences between ISO and RSU are-

1. RSU will vest after certain years have passed, generally five years. Therefore, the employee must stay at the company to exercise his option.
   Conversely, the ISO does not have such a long vesting period.
2. RSU can be converted to either stock or cash in the future, but ISO can only be purchased in cash at the exercise price.

Incentive Stock Option vs. Stock Appreciation Right

A stock appreciation right (SAR) is a form of equity compensation tied to the company's stock price to reward and retain employees. It benefits the employees as they can take advantage of the increased stock value.

Both ISO and SAR can be used to attract and retain talented employees, but there are critical differences between these types of stock that companies can offer.

1. In stock appreciation, employees can exercise or receive an award after it has vested without paying for it before it expires. Conversely, in the case of ISO, employees are required to pay an exercise price to get the award after it has vested before it expires.
2. Employees can be paid out in cash and shares once they have exercised SAR, but in ISO, employees are paid out in stock shares. 
3. In SAR, employees don't have to use their money to buy stock or stock options, but it is not the case with ISO. In ISO, an employee needs to pay in cash to purchase the share; however, the price will be the initially decided exercise price.

What should you choose?

It all depends upon the individual and company goals as to which of the above three options is better.

Depending on the tax treatments, those who want a long-term investment can go towards an ISO or NSO. However, those who want compensation in cash and long-term involvement with the company can use RSU.

In contrast, the right of stock appreciation may be more desirable to those seeking an immediate payoff.

An incentive stock option is a right option if you-

• Want to have a tax on capital gains rather than on regular income?
• Desire to have the stocks of the company in which you are working.
• Want to earn additional compensation over and above the salary as you will earn a profit if the stock price gets appreciated. 
• Are ready to pay the exercise price in cash since the ISO requires the employee to buy the share offered by the company in cash.
• Can wait till the options vest, and you have the opportunity to exercise your right to buy the share at a future date.

Researched and authored by Yashasvi Jain

Reviewed and edited by Parul Gupta | LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Investment Banking Salary Guide
• Investor Salary Guide
• Office Manager Salary Guide
• Phantom Stock Plan
• Private Equity Salary Guide