Incentive stock options revisited.

• Author: Kahen, David E.

1. Introduction

   There is increasing interest among corporate employers in the use of incentive stock options (ISOs) qualifying under section 422 of the Internal Revenue Code of 1986 as a part of employee compensation. Like other types of options, ISOs provide a reward to employees that is tied directly to the value of the stock of the corporate employer, thereby providing employees with an incentive to improve the corporation's overall performance.

   From an employee's perspective, ISOs offer generally more favorable tax treatment than non-qualified stock options and other equity-based compensation such as restricted stock. If specific requirements are satisfied, the gain realized by an employee upon exercise of an ISO is not subject to tax at that time, and no gain is recognized for so long as the shares are not sold or otherwise disposed of. Moreover, if an individual exercising an ISO holds the shares so acquired until death, the excess of the fair market value of the stock over its basis will escape income tax entirely by reason of the step-up of basis at death. If and when shares acquired by an employee through the exercise of an ISO are sold by that individual for an amount exceeding cost, the amount realized, as reduced by the holder's basis for the shares, is taken into account as capital gain if the shares are capital assets in the hands of the holder (as is generally the case).

   The employer corporation does not receive a deduction in connection with the grant or, in general, the exercise of an ISO. Compared with employee stock purchase plans qualifying under section 423 and other tax-qualified plan arrangements, however, ISOs offer greater flexibility because they are not subject to minimum participation and nondiscrimination rules. Thus, a corporation can direct the grant of ISOs to those employees who are most valuable or most in need of an incentive linked to company performance, and to those employees most likely to benefit from the special tax characteristics of ISOs.

   Incentive stock options have become more attractive recently for several reasons. The strong stock market performance over the past decade has fueled interest in stock options and other forms of equity-based compensation. In addition, senior management appears to be increasingly of the view that, to improve overall business performance, the rewards associated with improved results should be shared broadly among employees rather than limited to senior executives.(1) Incentive stock options are attractive and readily understood by managers and others as an opportunity to participate in corporate growth. Also, in contrast to performance-based compensation payable in cash, stock options do not adversely affect cash flow and, generally, do not detract significantly from corporate earnings as computed for accounting purposes.

   Finally, the increasing rates of tax on ordinary income over the past decade (now approaching 50 percent for some individuals in the top brackets who are also subject to state and local income taxes), when coupled with recent reductions in tax rates on capital gains and increasing sophistication regarding the means and potential benefits of deferring the recognition of gain indefinitely, have substantially enhanced the appeal of ISOs.

   The case for ISOs is even more compelling for-start-up or other corporations with no current taxable income or substantial net operating loss carryovers, for which the unavailability of tax deductions upon the grant or exercise of ISOs is less significant.

   Part II of this article describes the basic rules relating to the grant of ISOs, and Part III analyzes certain requirements relating to the exercise of such options. Part IV addresses the tax consequences of the exercise of ISOs, including the adverse consequences of an early sale or other disposition of stock acquired through the exercise of an ISO. Finally, Part V discusses the potential additional benefit of providing in the option plan for the use of previously acquired shares of employer stock to pay the exercise price under an ISO, and explores other means of facilitating the exercise of ISOs by employees.

2. ISO Qualification Requirements

   Limited to Employees. An option to purchase stock can qualify as an ISO only if the option is granted to an individual in connection with the individual's employment by a corporation, and only if granted by the employer corporation or its parent or subsidiary corporation (i.e., a corporation in an ownership chain beginning or ending with the employer corporation, with each corporation linked to the others by not less than 50-percent stock ownership as determined by voting power). The option must grant the holder the right to purchase stock in the employer corporation or its parent or subsidiary.

   Taking into account the increasing use by corporations of partnerships and limited liability companies for joint ventures, it is noteworthy that ISOs cannot be granted to employees of partnerships (or other entities, such as limited liability companies, that are treated as partnerships for tax purposes), even if the partnership is controlled by a corporation that has adopted or could adopt an ISO plan. It is hoped that future legislation will address this subject.

   Adoption of Plan. Incentive stock options must be granted pursuant to a plan approved by the shareholders of the corporation granting the options within 12 months before or after the date on which the plan is adopted.(2) The plan must specify the aggregate number of shares of stock that may be issued under options and the employees or class of employees eligible to receive options. The plan need not, and typically does not, specify the individuals to receive options; that responsibility is usually delegated to a person or committee appointed pursuant to the plan.

   Maximum Term of Plan and Options. Each ISO granted under a plan must be issued within 10 years of the adoption of the plan, and an ISO must not be exercisable after the 10th anniversary of the date of grant.(3)

   Exercise Price. For an option to qualify as an ISO, the exercise price cannot be less than the fair market value of...