Incentive Stock Options Requirements

Incentive stock options provide an income-tax free means of compensation. business charts with us money image by Andrew Brown from Fotolia.com

Although the Internal Revenue Service regulates incentive stock options, incentive stock options are less regulated and therefore less taxed than their counterparts, non-qualified stock options. In addition to tax regulation, the company that issues the option may also regulate vesting times and how long employees may hold options before they revert to the company.

Company Regulations

When a company grants incentive stock options, or ISOs, as part of a compensation package, it's usually part of a strategy to retain workers at that position. Most options don't immediately mature, so employees must continue to work at the firm to capitalize on the stock option portion of their compensation. Companies that issue the options may structure the plan as they see fit, setting the length of time an employee must wait for the option package to mature and be available to purchase stock at the option prices, a transaction known as vesting.

Permanence of ISOs

In most cases, stock options aren't the intangible property of the employee to which they are granted and companies may revoke non-vested options from employees as they leave the firm. Because options packages are a retention tool, they don't serve their purpose if they remain valid after an employee leaves the company. Reclaiming options from employees who leave or are fired from a firm is perfectly legal in most cases. Most firms won't revoke options for a retiring worker.

Income Tax Regulations and ISOs

Taxpayers are not required to report incentive stock options as income, effectively providing companies and employees a means for tax-free income. By contrast, employees who receive non-qualified stock options are required to pay income taxes on the discount rate of the package they receive.

Gains Taxes and ISOs

While options and stocks acquired as part of an ISO are not subject to income tax, they're otherwise taxed normally as investments and are subject to capital gains taxes. Employees who sell optioned stock must report their profits---the difference between purchase price and sale price---to the Internal Revenue Service, which levies capital gains taxes on the profit-taking amount. Gains amounts vary widely depending upon how long an employee held the option before vesting it and how long the stock was held after purchase before it was sold. Employees who hold an option for at least a year before vesting it, then retain shares of stock for at least a year, get the most favorable gains-tax rates. currently at 20 percent for the 2010 tax year.

References

• Internal Revenue Service: Stock Options
• Smart Money: Taxes on Incentive Stock Options
• Turbo Tax: Incentive Stock Options
• Fairmark: Incentive Stock Options in General