Wednesday April 24, 2024

4.13.1 Incentive Stock Options

Incentive Stock Options

ISO:  There are many ways that corporations compensate, motivate and reward key executives and officers.

Option Price:  The specified price or "option price" must not be less than the stock's fair market value at the time the option is granted.

Exercising the Option During Life:  In general, an employee decides when, where, and whether or not to exercise his or her option.

Holding Period:  After an employee exercises an ISO, he or she is subject to a "holding period" with respect to the company stock.

Tax Consequences of an ISO:  There are three wonderful tax advantages of an ISO.

ISO and AMT:  For purposes of AMT, ISOs pose a potential problem.

Transfer Limitations, Charitable or Otherwise:  While there is a good deal of discretion with respect to exercising ISOs, there are many restrictions regarding who can exercise ISOs.

Planned Giving Options with "ISO Stock":  Once the ISO is exercised and the stock holding period is met, an employee has a great deal of flexibility.

ISO
There are many ways that corporations compensate, motivate and reward key executives and officers. Corporations may provide performance-based bonuses, preferential working environments and corporate perks, such as tickets to sporting events or use of the corporate jet.

Stock options are another popular way to attract and retain key personnel. These options generally come in two types - incentive stock options (ISO) and non-qualified stock options (NSO).

Under an ISO plan, an employee is granted the right (or option) to purchase company stock during a specified period of time for a specified price. See Sec. 422.

Option Price
The specified price or "option price" must not be less than the stock's fair market value at the time the option is granted. However, for an employee owning more than 10% of the company's stock, the option price must be at least 110% of the stock's fair market value.

Exercising the Option During Life
In general, an employee decides when, and whether or not to exercise his or her option. To exercise an ISO, an employee simply pays the option price and, in return, receives company stock. An employee, however, must exercise an ISO within 10 years of the grant date. If an employee owns more than 10% of the company stock, then he or she must exercise within five years of grant date.

Finally, no more than $100,000 in options may be exercised for the first time in any one year. See Sec. 422(d). The value of the options is determined on the date the options are granted.

Holding Period
After an employee exercises an ISO, he or she is subject to a "holding period" with respect to the company stock. See Sec. 422. In short, an employee must hold the company stock for two years after the option is granted or one year after the stock is transferred to the employee, whichever is later. If an employee satisfies the holding period, then a subsequent sale of the stock will produce long-term capital gain. The holding period for capital gain purposes begins when the option is exercised. However, if an employee does not meet the holding period, then a sale of the stock will produce ordinary income.

A disposition of the stock includes any sale, exchange, gift or transfer of legal title of the stock. There are several transactions that will not be deemed a disposition. See Sec. 424(c). For charitable purposes, the most relevant exception deals with transfers at the death, such as bequests.

Tax Consequences of an ISO
There are three wonderful tax advantages of an ISO. First, there is no income tax consequence when the option is granted. Second, there is no regular income tax consequence when the option is exercised (but there could be alternative minimum tax (AMT) consequences). Third, upon the eventual sale of the company stock, the employee will realize capital gain not ordinary income. In essence, the employee receives work-related compensation subject to capital gain rates instead of ordinary income rates.

These favorable tax advantages only apply if the ISO rules are followed strictly. Accordingly, any failure to comply with the ISO requirements will disqualify the option (i.e., turn the ISO into a non-qualified stock option).

Example 4.13.1A

Oscar Option is Vice President of Big Corp. Four years ago, Big Corp gave Oscar the option to purchase company stock for $10,000. The options qualify as ISOs. At the time of the grant, Oscar did not have to report any taxable income.

Big Corp stock is currently valued at $50,000. As a result, Oscar decides to exercise his ISO. Accordingly, he pays $10,000 for the $50,000 stock. The exercise of the ISO does not trigger any regular income tax consequence. (However, for AMT purposes, Oscar will have $40,000 of ordinary income.)

If Oscar holds the stock for more than a year, then his stock becomes long-term capital gain property. After two years of holding the stock, Oscar sells the stock for $55,000. As a result, he realizes $45,000 of long-term capital gain ($55,000 - $10,000).

ISO and AMT
For purposes of AMT, ISOs pose a potential problem. As stated above, the exercise of an ISO does not trigger any taxable income to the employee for regular tax purposes. However, upon exercising the ISOs, the employee will include for AMT purposes the difference between the option's exercise price and the company's stock price on the date of exercise. As a result, the employee may have taxable income after exercise despite the usually tax-favored status of ISOs.

Transfer Limitations, Charitable or Otherwise
While there is a good deal of discretion with respect to exercising ISOs, there are many restrictions regarding who can exercise ISOs. In particular, the employee is the only person who can exercise the ISO during his or her lifetime. Moreover, ISOs are generally not transferable during the employee's life. See Sec. 422(b)(5). Therefore, an employee may not transfer an ISO to charity or a planned gift, e.g. CRT, CGA or CLT. This limitation effectively removes any gift possibilities with ISOs. (For gift planning options with "ISO stock," see section below.)

As for noncharitable options, spouses, for instance, may not exercise the employee's ISO. Other ISO restrictions include: 1) may not be assigned pursuant to a divorce settlement, 2) may not be sold or used as collateral, and 3) may not be contributed to IRAs and other retirement plans.

Planned Giving Options with "ISO Stock"
Once the ISO is exercised and the stock holding period is met, an employee has a great deal of flexibility. Simply put, the employee now owns long-term capital gain property. In this way, the stock is similar to other types of highly appreciated stock. Thus, the employee may transfer the stock outright to charity or to a CRT or CGA. Accordingly, the tax rules applicable to gifts of appreciated long-term capital gain property will apply, e.g. 30% AGI limitation.

Case Studies on Incentive Stock Options

Extreme Makeovers for the Grantor Charitable Lead Trust, Part 5 - In Search of ISOs:   Lynn Burrows, 40, is a partner in her law firm and a very successful trial attorney. Lynn mainly represents class action lawsuits against large, multinational corporations. As a result of the high stakes and high dollar amounts involved, it is not uncommon for a jury to award a judgment of over $100 million.

Spicy Options for Restauranteur, Part 3:   Roger Garcia is CEO of The Enchilada Factory, a chain of upscale restaurants that serves Mexican food geared toward health conscious patrons. Roger opened his first restaurant 30 years ago. With initial table space for a mere 12 people, Roger never could have imagined that this company would grow to over 150 locations with revenue of $800 million per year. Not surprisingly, magazines and trade journals frequently request interviews with Roger and write about his amazing journey to the top.

Spicy Options for Restauranteur, Part 4:   Roger Garcia is CEO of The Enchilada Factory, a chain of upscale restaurants that serves Mexican food geared toward health conscious patrons. Roger opened his first restaurant 30 years ago. With initial table space for a mere 12 people, Roger never could have imagined that this company would grow to over 150 locations with revenue of $800 million per year. Not surprisingly, magazines and trade journals frequently request interviews with Roger and write about his amazing journey to the top.

Related Topics on Incentive Stock Options

4.13.2  Non-Qualified Stock Options:    There are many ways that corporations compensate, motivate and reward key executives and officers. Corporations may provide performance-based bonuses, preferential working environments and corporate perks such as tickets to sporting events or use of the corporate jet.

4.13.3  Bequest of Options:    IRD, or income in respect of a decedent, is generally the result of assets that have untaxed ordinary income or capital gain at the time of the decedent's death. However, unlike other assets, IRD assets do not receive a stepped-up basis. In fact, when a beneficiary receives an IRD asset, the beneficiary is subject to taxation on the asset, just as the original owner would have been subject to such taxation. See Sec. 691.

4.13.4  Testamentary CRT:    IRD, or income in respect of a decedent, is generally the result of assets owned by the decedent that has untaxed ordinary income or capital gain at the time of the decedent's death. However, unlike other assets, IRD assets do not receive a step up in basis at death. In fact, when a beneficiary receives an IRD asset, the beneficiary is subject to taxation on the asset, just as the original owner would have been subject to such taxation. See Sec. 691.

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