Incentive Stock Options

Jul 13 • Financial Planning • 570 Views • No Comments on Incentive Stock Options

What is it?

An incentive stock option is a right or option granted by the sponsoring corporation to its employees to purchase shares of the corporation’s stock at a certain price for a specified period of time, notwithstanding an increase in the value of the stock after the option is granted. It is sometimes referred to as a qualified or statutory stock option.

Example(s): Assume that as a result of her outstanding sales performance during the year, Marissa was given a bonus: an option to purchase 1,000 shares of stock at $10 per share within the next 10 years. Within 15 months, the value of the stock had risen to $15 per share. If Marissa chose to exercise her option at that point, she would pay only $10,000 for stock that was actually worth $15,000.

How do you exercise an incentive stock option?

Typically, an employee exercises the option by paying cash equal to the exercise price or by tendering shares of employer stock that he or she already owns. With respect to the stock method, the employee can engage in a nontaxable stock-for-stock exchange (under Internal Revenue Code Section 1036). Basis in the shares transferred becomes the basis in an equal number of the new shares.

When can it be used?

  • Corporation needs incentive to retain key employees
  • Cash bonuses are not available or appropriate
  • Executive (or employee) requires stock ownership as incentive
  • Stock has long-term growth potential
  • Current owners are willing to dilute their ownership

Note that incentive stock options can only be used by corporations; they are not available to the employees of a partnership or limited liability corporation (LLC).

Strengths

  • Tax deferral – The employee does not recognize income or capital gain until a disposition occurs (generally, that means until the stock is sold). Therefore, taxation is deferred. The amount recognized is the difference between the amount paid for the stock and the sale price.
  • Favorable capital gain rate – Assuming the holding period requirements are met, taxes are measured (in the year the stock is sold) at capital gain rates, which are usually more favorable than ordinary income rates. If the shares are held for at least two years from the date the option was granted and at least one year from exercise, the tax on sale is payable at a long-term capital gain rate. If the holding period requirements are not met, the gain is taxed as a combination of ordinary income and capital gain.
  • No withholding obligation on corporation.
  • Helps business to attract, motivate, and retain key employees.
  • Provides incentive for the employee by providing an ownership interest in the business.

Tradeoff

  • Employee may be subject to alternative minimum tax (AMT) – The employee may be subject to AMT in the year of exercise of the stock option because the exercise gives rise to an adjustment of AMT income. More specifically, the excess of the stock’s fair market value at the time of exercise over the option exercise price is a tax preference item that may trigger an AMT obligation.

Tax considerations

Income Tax

An employee will not recognize any taxable income on the grant of an incentive stock option. Tax is deferred until there is a disposition of the stock. (Disposition means any sale, exchange, gift, or transfer of legal title.) The price at which the option was exercised becomes the taxpayer’s basis in the stock.

The tax treatment on the disposition of the stock depends on whether the stock was sold by the employee within the proper  holding period. The holding period is the later of two years from the date of grant or one year from the date of exercise by the employee. A disposition of the stock prior to the expiration of the holding period will cause the recognition of “compensation income,” which is ordinary income tax treatment on the difference between the fair market value (FMV) of the stock and the option price on the date of exercise. This compensation income recognized is added to the basis of the stock. Any later increase in the value of the stock from the date of exercise to the date of disposition will be treated as capital gain (short- or long-term).

Example(s): Jack was granted an incentive stock option in Year 1 to acquire 1,000 shares of ABC stock at $10 per share. Six months later, he exercised his option when the FMV of the stock was $15 per share. Eleven months after buying the stock, Jack sold his 1,000 shares at $20 per share. Since he did not hold the stock for the required period of time, he has a disqualifying disposition on the date of the sale.

Example(s): In the year of the sale of his stock (the disqualifying disposition), Jack recognizes compensation income of $5 per share ($15-$10). He then adds the $5 per share income to the basis of his stock to arrive at a new basis of $15 per share. When he sells the stock at $20 per share, he has a short-term capital gain of $5 per share ($20-$15).

If the employee complies with the holding period requirements, by comparison, he or she will enjoy the more favorable long-term capital gain treatment when the stock is sold. To receive this tax treatment, the employee must not dispose of the acquired stock for: at least two years from the date the option was granted; and, at least one year after the employee exercised the option.

Caution: The employee may be subject to alternative minimum tax in the year of exercise of the stock option.

Gift and Estate Tax

Gifts of incentive stock options

A gift entails a transfer of the donor’s basis in the stock to the donee. A gift of incentive stock option stock should not be made until the statutory holding period has been met. Otherwise, the donor will recognize compensation income equal to the difference between the FMV of the stock and the option price on the date of exercise. Gifts of incentive stock options may be subject to gift tax.

Death of the incentive stock option holder

Incentive stock options are includable in the option holder’s gross estate for estate tax purposes. In general, the assets of a decedent are afforded a step-up in basis at death, and this rule applies to incentive stock options. A step-up in basis means that the FMV of the stock on the date of the employee’s death becomes the new basis for the stock. The basis of unexercised stock options is stepped-up to FMV at death as well.

Example(s): If John had an option to purchase $10,000 shares of stock at $10 per share and the value of the stock had risen to $15 per share at his date of death, John’s executor or administrator would use $15 per share (the FMV at date of death) for the stock basis.

Caution: If the estate of a person who died in 2010 elects out of the estate tax, assets transferred at death will not receive a step-up in basis but will receive a carryover or modified carryover basis instead.

For more information, visit our website at makinglifecount.com or contact Matt Starkey–mstarkey@makinglifecount.com, (913) 345-1881.

This information was developed by Forefield, Inc. an independent third party. It is general in nature, is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. Investments and strategies mentioned may not be suitable for all investors. Past performance may not be indicative of future results.  Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016

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