Employees, does your employer offer incentive stock options (ISOs)? ISOs provide big tax benefits if you follow certain rules. Here’s what you should know.

What are ISOs?

An incentive stock option is a company benefit that gives an employee the right to buy stock shares at a discounted price with the added appeal of a tax break on the profit. The profit on ISOs is taxed at the capital gains rate, not the higher rate for ordinary income.

To whom are ISOs offered?

Generally, ISO stock is awarded to top management and highly-valued employees. Companies often use ISOs to encourage employees to stick with a company long-term.

What are the tax rules?

Ordinarily you don’t owe any federal income tax when you exercise an ISO granted to you by your company. Also, if you meet the following two requirements, your gain when you eventually sell the option shares will be treated as lower-taxed long-term capital gain:

1. You hold the option stock for more than one year after the option exercise date
2. The date you sell the option stock is more than two years after the option was granted.

What qualifies as an ISO?

The following conditions must be met to qualify as an ISO:

• The option is granted under a plan specifying the number of shares of stock to be issued and the employees’ eligibility to receive them.
• The stockholders approve the plan within 12 months of adoption.
• The option is granted within the earlier of ten years of the date the plan is adopted or the date of stockholder approval.
• The option is exercisable only within ten years of the date it is granted.
• If the employee receiving the option owns more than 10% of the voting power of the employer’s stock (not counting the option stock), the option price must equal or exceed 110% of the fair market value of the stock when the option is granted.
• The option cannot by its terms be transferable other than at death and can’t be exercisable during the employee’s life by anyone other than the employee.

Drawbacks?

Bear in mind that there are several potential drawbacks to ISOs. These include:

1. The company cannot claim a deduction when you exercise.
2. The bargain element on the exercise of the ISO is an adjustment for purposes of. calculating the alternative minimum tax (AMT).

You’ll want to consult your tax advisor about the AMT ramifications in your specific situation. We can help. Contact us.