This Checklist was reviewed in May 2013 by our editorial team as part of ongoing maintenance. This Checklist is also continually monitored for necessary changes due to legal or practice developments.
This Checklist outlines the requirements that must be satisfied for a stock option to qualify as an incentive stock option (ISO) under Section 422 of the Internal Revenue Code and receive more favorable employee tax treatment than non-qualified stock options.
Incentive stock options (www.practicallaw.com/1-502-4585) (ISOs) provide employees with more favorable tax treatment than non-qualified stock options. An individual who exercises a non-qualified stock option must pay ordinary income taxes on the excess of the fair market value of the underlying shares on exercise over the exercise price (the "spread"). However, ISOs are not subject to ordinary income taxes if the shares are held for both:
one year from the date of exercise; and
two years from the grant date.
An employee incurs no income tax at grant or on the exercise of an ISO (although the spread is a tax adjustment item for purposes of calculating alternative minimum tax) and the profit (if any) made on the sale of the shares is taxed as long-term capital gain.
From the employer's perspective, ISOs are less attractive than non-qualified stock options, because the employer is not entitled to a tax deduction on an employee's exercise of an ISO, if the employee meets the above holding requirements.
For more information on the taxation of ISOs, see Practice Note, Overview of the Taxation of Equity Compensation Awards: Incentive Stock Options (www.practicallaw.com/7-505-9204) and Taxation of Equity Compensation Awards Chart: Incentive Stock Options (ISOs) (www.practicallaw.com/9-518-2627).
The terms of the option must not provide that the option will not be treated as an ISO.
The option must be granted to an individual in connection with that person's employment by the corporation granting the option (or by a related corporation as defined in Treasury Regulation Section 1.421-1(i)(2)).
The option must be for the purchase of stock of the employer or a related corporation.
The option must be granted under a formal plan (which may be in written or electronic form) that is approved by shareholders of the granting corporation within 12 months before or after the date the plan is adopted by the corporation.
The plan under which the ISO is granted must include:
the maximum aggregate number of shares which may be issued through the exercise of ISOs; and
the employees or class of employees who are eligible to receive options or other stock-based awards under the plan (and if non-employees are eligible to receive awards under the plan, the plan must separately designate the employees or class of employees eligible to receive ISOs).
The option must be granted within ten years from the earlier of:
the date the plan was adopted; or
the date the plan was approved by shareholders.
The terms of the option must state that the option is not exercisable beyond ten years after the date the option was granted (or five years after the option was granted to an employee who owns shares accounting for 10% or more of the total combined voting power of all classes of stock of the corporation, its parent or its subsidiary (ten-percent shareholder)).
The exercise price of the option must not be less than:
the fair market value of the underlying shares on the grant date for employees who are not ten-percent shareholders; or
110% of the fair market value of the underlying shares on the grant date for employees who are ten-percent shareholders.
The terms of the option must:
prohibit the transfer of the option by the employee, other than by will or the laws of descent and distribution; and
provide that the option is exercisable only by the employee during the employee's lifetime.
For each employee, the aggregate fair market value (determined as of the grant date) of stock purchased by exercising ISOs that are exercisable for the first time in any calendar year cannot exceed $100,000.
The option holder must be an employee of the corporation granting the option or a related corporation at all times during the period beginning on the grant date and ending on the date that is three months before the date of exercise. This means that, except in the case of the employee's termination due to death or permanent and total disability, if the option holder's employment terminates, the option holder must exercise the option no later than three months after his termination date.
If the employee's employment terminates due to permanent and total disability, the option must be exercised no later than one year after the employee's termination date.
If the employee's employment terminates due to death, the option holder's heirs can exercise the option until the option's expiration date.
An option that otherwise qualifies as an ISO does not fail to be an ISO because it contains any of the following provisions:
The option holder is permitted to pay the exercise price with previously acquired shares of the corporation that granted the ISO.
The option holder has the right to receive additional compensation when the option is exercised, if the additional compensation is includible in income under Section 61 or Section 83 of the Internal Revenue Code.
The option is subject to a condition or grants a right that is not inconsistent with the ISO rules.