ISO

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Incentive Stock Option (ISO)

An ISO is a type of stock option. An ISO qualifies for advantageous tax treatment for the recipient: Instead of paying ordinary income tax on the difference between the exercise price and fair market balue, the holder of the option pays only long-term capital gains tax on the spread. However, to qualify, the transaction must meet several requirements:

  • The purchased shares must be held by the individual for at least 2 years after the grant of the option and 1 year after the exercise of the option.
  • The individual must be a continuous employee of the company from the time of grant to no earlier than 3 months (12 months, if disabled) before the date of exercise.

In addition, to be an ISO, an option must:

  • be granted as part of a written plan that includes the total number of shares that may be issued as options and the employees (or class of employees) to whom they may be granted;
  • be part of a plan that is approved by the shareholders within 12 months before or after the grant;
  • be granted within 10 years of the establishment of the plan or its approval by shareholders, whichever is earlier;
  • be exercisable no later than 10 years after grant;
  • be issued with an exercise price of at least fair market value;
  • be prohibited from transfer (except by will) and exercisable only by the recipient; and
  • not be granted to an individual with more than 10 percent of the total combined voting power of all classes of stock of the employer (with some exceptions).

An important drawback of ISOs is that the cost of an ISO cannot be deducted (at any point) by the issuing corporation.

See Code Section 422.

Reporting

ISOs can trigger reporting obligations under Code section 6039 and its associated regulations.

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