What Are Incentive Stock Options?
What is an incentive stock option? Good question! Let’s define and illustrate the concept of incentive stock options as simply as we can.
Incentive stock options (also known as an “ISO”) are stock options that have reached tax requirements that entitle the buyer of the option to a benefit in his taxes. Incentive stock options are not assessed with a regular tax rate when they are granted and exercised. If they are held for a specified length of time, taxes on this incentive stock option are taxed as long term capital gains, rather than regular income. In other words, this form on an option allows you to treat any profits realized as capital gains at a low tax rate, rather than regular income at a much higher tax rate.
Let’s put this lengthy definition into a practical application. We’ll also add an explanation on the “timing requirement” for incentive stock options.
Let’s say that John works for Ace Plumbing Supply. Ace has granted John an employee stock option on January 1, 2004. John executes that employee stock option on January 2, 2005 by purchasing the shares at the agreed upon price. John then sells those shares of stock in Ace on January 3, 2006. John realizes a profit from the sale of his option of $100,000.
How will this profit of $100,000 be taxed? Will it be assessed as regular income (a high tax rate), or as long term capital gains (a comparably low tax rate)? To answer this we have to determine if this is an incentive stock option (ISO), or not. If it is an ISO, this profit is treated as a long term capital gain. If it is not, this profit is treated as regular income.
How do we determine if John’s profit from sale of his shares is an incentive stock option, or not? We must determine if the “holding period test” has been met. The holding period test is a two part test (you must meet both conditions for a qualified ISO) as follows:
1- Was there a period of at least two years between the grant date and the sale of the shares?
2- Was there a period of at least one year between the exercise date and the sale date of the shares?
Now let’s apply the holding period test to John’s scenario:
1- Was there a period of at least two years between the grant date and the sale of the shares? Yes! John was granted the employee stock option on January 1, 2004. He then sold the shares on January 3, 2006. There was more than 2 years between the grant and sale dates, so John passes the first part of the holding period test.
2- Was there a period of at least one year between the exercise date and the sale date of the shares? Yes! John exercised his options on January 2, 2005. He then sold the shares on January 3, 2006. There was more than 1 year between the option exercise date and the sale date. So John passes the second portion of the option holding period test.
As we can see, John will be able to treat his profit of $100,000 from this employee stock option as a long term capital gain when he pays his taxes, rather than regular income, thanks to the concept of incentive stock options. Congratulations John!
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Tags: capital gains, incentive stock options, income, options, shares, stock options, stocks, taxes
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