INCENTIVE STOCK OPTIONS

The incentive stock option (ISO) is the current form of stock option plan eligible for special tax benefits, which are provided by Code Section 422. Under an ISO plan, the usual tax rules previously discussed do not apply. Instead, for stock purchased under an ISO plan, there is no taxation to the employee until the stock is sold. Employees do not realize any taxable income when they receive the option, even if the option has an ascertainable fair market value and, furthermore, there is no taxable income when the option is exercised. However, the difference between the option price and the fair market value at the time of exercise is a tax preference item that may be subject to the alternative minimum tax. Because there is no regular taxable income to the employee at either the grant or the exercise of the option, the corporation gets no deduction at any time.

Options under an ISO plan must generally be granted to employees within ten years of the plan's adoption or approval by the shareholders, and an option must be exercised by the employee within ten years after it is granted. The option price must equal or exceed the stock's fair market value at the time the option is granted. Any good-faith attempt to value stock will be acceptable if there is no readily established market.

ISO plans increase the tax benefit of stock options as a form of compensation by providing increased tax deferral and, therefore, represent an attractive executive benefit. However, they are most likely to be used in large corporations. If an option holder has stock with more than 10 percent of the total combined voting power of the employer corporation, taking certain stock attribution rules into account, there are additional restrictions on ISO plans that may make them unattractive for closely held corporations. In such cases, the option price must be at least 110 percent of the stock's fair market value at the time it is granted and the option must be exercised within five years after it is granted rather than ten. Also, an employee receives the maximum tax benefit from an ISO plan only when the stock is sold, and there may be no ready market for a stock of a closely held corporation. Furthermore, it may be undesirable to pass ownership of stock in a closely held corporation to outsiders. However, the plan may permit the employee to exercise an option and pay for the shares of stock with other stock of the employer.

The aggregate fair market value of stock for which an employee can be granted an option under an ISO plan during a single calendar year cannot exceed $100,000. There are carryover provisions if the employee does not use the full limit in any year.