Incentive Stock Options (ISOs): Definition, Benefits and Example

An incentive stock option

incentive stock option
Incentive stock options (ISOs) are popular measures of employee compensation received as rights to company stock. These are a particular type of employee stock purchase plan intended to retain key employees or managers. ISOs often have more favorable tax treatment than other types of employee stock purchase plan. › stocks

(ISO) is a corporate benefit that gives an employee the right to buy shares of company stock at a discounted price with the added benefit of possible tax breaks on the profit. The profit on qualified ISOs is usually taxed at the capital gains rate, not the higher rate for ordinary income.

Incentive Stock Options: The Basics & Taxes

Characteristics of incentive stock options

The distinctive traits of incentive stock options set them apart from other stocks. The price of the shares you buy from an ISO is predetermined. Fixed prices can be less than market value, so if you choose to purchase these options, you could make a sizable profit.

Since incentive stock options are not treated as ordinary income for tax purposes, you do not need to report them as income. You merely disclose taxable income when you sell the stock, not otherwise. It’s crucial to remember that incentive stock options do eventually expire.

When deciding whether to accept an ISO, it’s crucial to keep in mind that you must hold the shares for at least a year after exercising the option and two years after the grant. Exercise refers to the day you purchase the shares. The day your business hands you the grant document is known as the grant date.

The gain from selling your shares will be taxed at a lower rate if you hold off until after the two-year grant period. This is called a qualified disposition. You’ll pay a higher tax rate if you sell your shares before the two-year window closes. This is called a disqualified disposition.

What are incentive stock options?

Employees who receive incentive stock options, also known as statutory stock options, are given company shares. In addition to salaries, businesses offer ISOs, and many offer options to make up for lower pay or fewer benefits. Employees who invest in a company stand to benefit financially more overall.

Employees of both public and private companies are given incentive stock options. However, since public companies tend to be bigger and have publicly traded stocks, they tend to use ISOs more frequently.

The benefit of incentive stock options

Incentive stock options have some advantages, the most prevalent of which is taxation. You pay less in taxes when you decide to sell your shares if you keep them for a long enough period of time. You can keep these shares for as long as you like without paying taxes until you sell them because they aren’t taxed like regular income is.

You can accrue a sizable profit from your shares over time. In addition to owing a portion of the company, you also gain from its expansion.

How do incentive stock options work?

Employees can typically purchase a set number of ISOs from their employers for a specific price. Companies typically set vesting periods to encourage employees to stay for a number of years. An employee must wait a certain amount of time before they can actually purchase the shares, which is known as the vesting period. ISOs typically partially vest over a period of several years, similar to many retirement plans.

You can purchase 25% of the shares at the end of the first year, 50% at the end of the second year, 75% at the end of the third year, and 100% at the end of the fourth year, for instance, if you purchase ISOs with a four-year vesting period.

Example of incentive stock options

Although each company’s incentive stock options are different, the general strategy is the same. Consider this example:

You purchased an option for 100 shares at the strike price of $1. Altogether, you pay $100. The vesting period is four years.

If you decide to exercise the option, and four years later the stock is trading at $10 per share, you will have made a $9 profit on each share you bought.

Differences between incentive stock options and non-qualified stock options

It’s crucial to understand the differences between non-qualified stock options and incentive stock options.

Before they can be accepted, ISOs need to be given to the employee. In addition to direct employees, the company also offers NSOs to partners and vendors. NSOs are typical in new businesses because they want to take into account everyone who was involved in starting the business.

However, the primary distinction between ISOs and NSOs is how they are taxed. You must pay the difference between the exercise price and grant price for NSOs at the standard income tax rate.

Frequently asked questions

Review these frequently asked questions to learn more about ISOs:

Why does my company not offer stock options?

Not all companies offer stock options. The choice of how to pay its employees is entirely up to the business. Instead of ISOs, you might receive other benefits like comprehensive health insurance and a higher salary.

Do I have to accept stock options?

You are not required to accept incentive stock options. To determine whether you should buy ISOs, do some research or ask a financial advisor or accountant for guidance.

When should I exercise my stock options?

You should consider a number of factors when deciding when to exercise your stock options. Think about your financial objectives, your need for additional funds, and the state of the economy right now. You should also be aware of the timeframe for your ISOs’ vesting period if it applies. Additionally, keep in mind that in order to avoid paying additional taxes, you must wait two years from the date of the grant.


Are stock options a good incentive?

Additionally, giving employees stock options can help them resist the temptation to leave and join a rival company. However, opponents of stock options caution that they may persuade executives to adopt tactics that may boost the stock price in the short term but may harm the business in the long run.

Who is eligible for incentive stock options?

ISOs can only be granted to employees. Therefore, non-employee independent contractors and board members are not eligible to receive ISOs. The only amount that qualifies for ISO treatment is the first $100,000 that becomes exercisable in any 12-month period.

What are stock options compensation?

Stock options are a form of compensation. Companies can grant them to employees, contractors, consultants and investors. These options, which are contracts, give a worker the right to purchase, or exercise, a predetermined number of shares of company stock at a fixed price, also known as the grant price.

What are stock based incentives?

Employees, executives, and directors of a company are paid using stock-based compensation, also known as share-based compensation or equity compensation.

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