Examples of Incentive Stock Options

Stock options are a form of compensation.

Incentive stock options are a way to give employees a stake in their company and reduce their tax rate. This is done by allowing them to buy a stock in the future at its past price, thus netting them a bargain if the price has risen.

Positive Example

In 2010, an executive is granted options to purchase 1,000 stocks at a price of $1. In 2011, the price has risen to $2, so he buys 100 shares at $1, then sells them at $2, thus making $100.

Negative Example

An executive in a competing company is granted the same deal. In 2011, the price has risen from $1 to $2, so he exercises his option to purchase $100 in stocks. However, rather than sell immediately, he holds them in anticipation of a further rise in value. In 2011, the stock price drops to $0.50. The stock he purchased has now declined in value by 75 percent of its $2 high, representing a 50 percent loss on his $100 investment.

Tax Example

An executive is very well-compensated and his $500,000 salary is taxed at 30 percent, or $150,000. He also exercises $500,000 worth of stock options each year. These stock options are only taxable when he sells them, and when he does so they are taxed at the capital gains rate, which was 15 percent in August 2010. Half his salary is therefore taxed at a lower rate in exchange for higher risk.

References

• Investopedia: Get The Most Out Of Employee Stock Options
• IRS: Tax Topics: Topic 409: Capital Gains and Losses