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In Search Of… ISOs

—RMZ

Many startups use stock options to incentivize key employees to remain in the employ of the company and contribute to its long-term growth. From a tax perspective, two types of stock options may be issued: (i) “non-qualified” stock options and (ii) “incentive stock options” (often referred to as “ISOs”). Each of these stock options has significantly different tax treatment to both the grantee and the company. This article will focus only on the tax treatment relating to the grantee.

Although ISOs have a more beneficial tax treatment to the grantee, non-qualified stock options are much more commonly issued. The reason for this is that strict requirements must be followed by the grantee in order for the stock option to qualify as an ISO and receive more favorable tax treatment. Those requirements more often than not result in non-qualified options being issued.
Generally, there is no taxable event to the grantee upon the issuance of a stock option – whether it be a nonqualified stock option or an ISO. However, there is a distinct tax difference between a non-qualified option and an ISO upon exercise of the option. If an option qualifies as an ISO, there is no tax due upon exercise of the option. If an option is a non-qualified option, then at the time of exercise, the grantee must pay tax at ordinary income rates on the difference between the exercise price and the fair market value of the shares issued. For ISOs, the grantee only pays tax at the time the grantee sells the underlying option shares; and then pays the lower long term capital gains tax rate.
Certain requirements must be met in order for a stock option to qualify as an ISO. We outline some of those requirements below.

Requirements:

To qualify as an ISO, Section 422 of the Internal Revenue Code (the “Code”) and Sections 1.421-1.424 of the Treasury Regulations require that each of the following conditions are satisfied:

1. The option must be granted pursuant to a plan which includes the aggregate number of shares which may be issued under options and the employees (or class of employees) eligible to receive options.

a. A plan that merely provides that the number of shares that may be issued as an ISO under such plan may not exceed a stated percentage of the shares outstanding at the time of each offering or grant under such plan does not satisfy this requirement. Rather, the maximum aggregate number of shares that may be issued under the plan may be stated in terms of a percentage of the authorized, issued, or outstanding shares at the date of the adoption of the plan.

b. The plan must also indicate the employees (or class or classes of employees) eligible to receive the options or other stock-based awards to be granted under the plan. This requirement is satisfied by a general designation of the employees (or the class or classes of employees) eligible to receive options or other stock-based awards under the plan, such as “key employees of the corporation”; “all salaried employees of the corporation and its subsidiaries, including subsidiaries which become such after adoption of the plan;” or “all employees of the corporation”.

2. The plan must be approved by the stockholders of the granting corporation within 12 months before or after the date such plan is adopted.

3. The option must be granted within 10 years from the date the plan is adopted, or the date the plan is approved by the stockholders, whichever is earlier.

4. The option by its terms must not be exercisable after the expiration of 10 years from the date the option is granted.

5. The option price must not be less than the fair market value of the stock at the time the option is granted.

a. For purposes of this section, the fair market value of stock shall be determined without regard to any restriction other than a restriction which, by its terms, will never lapse. In other words, fair market value is determined without regard to restrictions that will lapse, including restrictions subject to substantial risk of forfeiture. Notwithstanding the foregoing, any reasonable valuation method may be used to determine whether, at the time the option is granted, the option price satisfies the pricing requirements of this section with respect to the stock subject to the option.

6. The option by its terms must not be transferable by the optionee, except by will or the laws of descent and distribution, and must be exercisable, during the optionee’s lifetime, only by the optionee. It is important to note that the transfer of an option to a trust does not disqualify the option as an ISO if, under applicable State law, the optionee is considered the sole beneficial owner of the option while it is held in trust.

7. The Optionee, at the time the option is granted, must not own stock possessing more than 10% of the total combined voting power of all classes of stock of the employer corporation or of its parent or subsidiary corporation. This restriction, however, will not apply if, at the time the option is granted, the option price is at least 110% of the fair market value of the stock subject to the option and the option by its terms is not exercisable after the expiration of 5 years from the date the option is granted.

8. The determination of whether an option is an ISO is made as of the date the option is granted. An option which qualifies as an ISO when granted does not lose its character as such an option by reason of subsequent events, and an option which does not qualify as an ISO when granted does not become such an option by reason of subsequent events. It is important to note, however, that the amendment of the terms of an ISO may cause it to cease to be an ISO.

It is critically important that stock option plans and particularly those offering ISOs are properly set up. Please contact RMZ for questions involving stock option plans for your company.