Clients frequently ask if they can provide incentive compensation to their employees and executives in a manner that gives them flexibility and drives performance, but receives coveted capital gains treatment. This usually sounds too good to be true. In most cases, you can defer or sometimes minimize income tax for employees (retirement plans, deferred compensation arrangements, stock appreciation rights, non-qualified stock options), but there is one tool that enables employees to skip income tax, FICA, and withholding altogether – well-designed and-well managed incentive stock options or “ISOs.”
Incentive stock options – sometimes called statutory options because they are established and governed by Internal Revenue Code 422 – are a kind of stock option that can provide “special” tax treatment to the recipients if certain requirements are satisfied. There are two key differences between incentive stock options and their more common cousin – the non-qualified stock option:
- First, executives will not recognize any ordinary income tax at exercise of an ISO (as compared to a non-qualified option – which requires executives to recognize ordinary income on the spread – or difference between the exercise price and the value of the option on the date of exercise – and come up with money to pay their withholding on that amount). This can be a big benefit as long as the exercise does not end up triggering the AMT (which has historically been an issue for many incentive stock option holders, but is less likely now in light of changes made to the AMT by the Tax Cuts & Jobs Act).
What is AMT? At a very high level, the Alternative Minimum Tax (AMT) is simply an alternative tax structure to the more well-understood and more often used regular income tax method. In order to determine which tax to apply, taxpayers must calculate taxes under the regular income tax method and the alternative minimum tax and then pay whichever amount is greater. This does not come up particularly often for most normal taxpayers, but is relevant for most ISO recipients because the value of the spread at exercise is not taken into account under the regular tax method, but it is considered as a preference item in the AMT method. The larger the spread, the more likely ISOs will trigger the AMT.
- Second, if all of the statutory requirements are satisfied, then the gain – the difference between the incentive stock option’s exercise price (generally, the fair market value of the stock on the date of grant) and the amount the holder will receive when she ultimately sells the stock after exercise – will all be taxed at the lower capital gains rate (currently, 15 percent or 20 percent, depending on income level), rather than income tax (the top tax bracket is currently at 37 percent), and no FICA or withholding obligations will apply. That is a tax savings of more than 17 percent!
The flipside is that ISOs are less tax advantageous to employers because, if all goes as planned, they will never be permitted to take a deduction for the compensation. However, because the corporate tax rate was reduced with the Tax Cuts & Jobs Act, some employers are taking a second look at whether to issue ISOs now, considering that the deduction is now less valuable.
To receive this special treatment, the plan document, award agreement, and management of the incentive stock option award must meet certain requirements:
Plan and Award Agreement
- Incentive stock options must be issued pursuant to an equity incentive plan.
- The plan must provide the number of shares reserved for issuance as ISOs.
- The plan must be approved by the company’s shareholders within 12 months before or after it is adopted by the company, and re-approved at least every 10 years thereafter.
- The award agreement must provide an exercise price that is no less than the fair market value of the stock underlying the options on the date of grant (100 percent of the fair market value for 10 percent owners). [This will also help with Code Section 409A compliance.]
- Each award must have a stated term of no more than 10 years (five years for 10 percent owners).
Eligibility and Operation
- ISOs may only be issued to employees – not to consultants or non-employee directors.
- ISOs may only be issued by corporations.
- No more than $100,000 of ISOs may become exercisable in any given calendar year (based on the fair market value on the grant date). [This seems straightforward until companies add fancy features like accelerated vesting on a change in control event.]
- Certain limits on post-termination exercise apply, notably ISOs must be exercised within three months of a standard termination (longer periods apply in the event of death or disability).
- After the option is exercised, and stock is actually purchased, the stock must be held until the later of (i) the second anniversary of the grant date or (ii) one year from the exercise date. [This tends to be one of the most difficult requirements to satisfy because many employees want to wait to exercise until a liquidity event – or change in control – but will not satisfy the holding period if they sell their stock shortly after exercise.]