No matter what the status of current economic conditions, businesses often compete to hire the best, most talented people possible. Employees who are choosing between different companies consider the entire employment package being offered including working conditions, paid time off, benefits and, of course, compensation. Compensation includes not only salary but also bonuses and stock options. Incentive stock option agreements are one type of compensation that can be beneficial to both employees and employers.
What is an Incentive Stock Option Agreement?
In order for a stock option to qualify as an incentive stock option, it must meet all of the requirements set forth in Section 422 of the Internal Revenue Code. Specifically:
· The employee does not sell his shares within 2 years of being granted the options and within 1 year of exercising the option;
· The employee remains an employee of the business from the date on which the incentive stock options were granted until at least three months after the options were exercised;
· The incentive stock option agreement must include the aggregate number of shares to be issued and the employees (or class of employees) eligible to receive the incentive stock options.
· The incentive stock option agreement must be approved by the company’s shareholders.
· The options must be granted within 10 years of developing or approving the agreement;
· The option price must be at least fair market value at the time the option is granted
· The option is not transferable from the eligible employee to others; and
· The employee receiving the incentive stock option does not own stock that gives the employee more than 10% voting power for the company.
Benefits of Incentive Stock Option Agreements for Employees
Employees who exercise incentive stock options have a tax advantage over employees who exercise other types of stock options. Employees are not required to pay ordinary income tax on the difference between the option price and the stock’s fair market value when they exercise an incentive stock option. As long as the employee owns the stock for at least one year from the date the employee exercised the option and for at least two years from the date the option was granted then the employee need only pay long term capital gain tax on the profit when the shares are sold. Long term capital gain tax is lower than ordinary income tax and the employee, thereby, pays less in taxes.
Benefits of Incentive Stock Options for Businesses
Businesses benefit from offering incentive stock options in a number of ways. First, incentive stock options may attract talented professionals to work for the company. It could be a deciding factor in a compensation package when a prospective employee is choosing between different employers. Second, it allows a business to provide meaningful compensation to an employee in a manner that is often less expensive than increasing the employee’s salary. Finally, employees who have an ownership interest, through shares of stock, may be more committed to remaining with the company and securing its profitability and growth.
Incentive stock options provide many benefits to employees and employers and are an important strategy for businesses to consider when hiring and retaining key employees.
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