Incentive Stock Options (ISOs)

Q: What is an incentive stock option (an “ISO”)?

A: An incentive stock option is a stock option that meets the criteria to qualify as an incentive stock option under Section 422 of the Internal Revenue Code. Among other things, ISOs have to be granted pursuant to shareholder approved plans.

ISOs are subject to tax treatment that is different, and potentially more favorable than the tax treatment accorded nonqualified or nonstatutory stock options.

You have to be an employee to receive an ISO. Thus, non-employee directors and non-employee advisors do not qualify and cannot receive ISOs.

Only $100,000 in ISOs can become exercisable during any 1 year.

Holding Periods

ISOs have 2 holding periods. You must hold the stock for 1 year after exercise, and 2 years after the date of option grant. Most ISO recipients fail to meet these requirements.

The benefits of ISOs?

  • If you meet the holding periods, your gain on the ultimate sale of the stock will be capital gain.
  • You will not have ordinary income on exercise, but the spread on exercise will be an AMT adjustment.
  • There is no employment tax withholding due on exercise of an ISO.

The trouble with ISOs?

  • Employees underestimate the AMT impact, and then cannot pay the AMT when it is due. Since there is no withholding, it is easy to get in trouble.
  • There is no deduction for the employer on an ISO for which the holding periods are met.

Q: Can an incentive stock option be granted to a part-time employee?

A: Yes.

Q: Can an incentive stock option be granted to an independent contractor?

A: No. ISOs can only be granted to employees.

Q: Can an incentive stock option be granted to a non-employee director?

A: No. ISOs can only be granted to employees.

Q: Are there reporting requirements for ISO exercises?

A: Yes.

Employers must now provide employees and the IRS a notice when employees exercise an ISO.

From the IRS web site:
“Forms 3921 and 3922. Forms 3921 and 3922 are required to be filed for certain stock transfers occurring after 2009. The filing of these information returns is required by section 6039, as amended by the Tax Relief and Health Care Act of 2006 (Public Law 109-432).

  • Use Form 3921 to report a corporation’s transfer of stock pursuant to an employee’s exercise of an incentive stock option described in section 422(b).
  • Use Form 3922 to report a transfer of stock by an employee where the stock was acquired pursuant to the exercise of an option described in section 423(c).”

Instructions page
Specific instructions for forms
Instructions (PDF version)
Form 3921
Form 3922

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