Using Incentive Stock Option Agreements to Attract and Retain Employees

Incentive stock option agreements are a type of compensation that can be beneficial to both employees and employers. Stock option plans can be a good option for startups who may not have the resources to pay higher salaries. It is also a way to incentivize workers to do their best work and benefit from higher stock values. You may also be able to get favorable tax treatment for your business if you do this.

You need to handle stock option agreements carefully for tax benefits and to attract and retain the best employees. If your company is considering using stock option agreements as an employee benefit, talk to an employment law attorney.

What Is an Incentive Stock Option Agreement? 

Incentive stock options (ISOs) are discounted company stocks with tax benefits. These have tax advantages over nonqualified stock options (NSOs). Taxes on ISO gains are at the capital gains rate instead of ordinary income. ISOs are generally aimed at attracting and keeping managers, supervisors, and highly qualified talent.

With an ISO agreement, qualified individuals can buy a certain amount of company stock at a discounted price. There is a vesting period and minimum time to be able to sell vested stocks. For a stock option to qualify as an incentive stock option, it must meet all of the Internal Revenue Code requirements:

• The employee cannot sell their shares within two years of the option grants and within one year of exercising the option
• The employee remains an employee of the business from the granted date on the incentive stock options until at least three months after exercising the options
• The incentive stock option agreement must include the aggregate number of shares issued and the employees (or class of employees) eligible
• The company’s shareholders must approve the incentive stock option agreement
• 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 of granting the option
• The option is not transferable from the eligible employee to others
• The employee receiving the incentive stock option does not own stock that gives the employee more than 10% voting power for the company.

How Can Incentive Stock Option Agreements Benefit Your Employees?

Employees who exercise incentive stock options have a tax advantage over 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.

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 granting the option, the employee needs to only pay long-term capital gains tax. Long-term capital gains tax is lower than ordinary income tax. As a result, the employee pays less in income tax.

What Are the Benefits of Incentive Stock Options for Your Businesses?

Your business can also benefit from offering incentive stock options. First, incentive stock options may attract talented professionals to work for the company. It could be a deciding factor in a compensation package for a prospective employee. However, prospective employees need to understand the tax implications of employee stock options.

Incentive stock options can also help hold onto key employees. The vesting schedule of ISOs requires the worker to stick around long enough to have their options vest. The holding period is an incentive to avoid the worker leaving to go to work for another company. They have invested in the company and the value of the stock. It gives employees an ownership interest, through shares of stock, to remain with the company. The employee has a financial interest to secure company profitability and growth.

ISOs also allow your business to provide meaningful compensation to employees that is often less expensive than a salary increase. You can offer stock purchases at a time when your startup company needs to use all available capital to invest in the growth of the business.

What Do You Need To Offer Stock Options to Prospective Employees?

There are strict tax code requirements for ISOs. An experienced lawyer can help you establish a stock option plan that provides the maximum benefits to employees and your business. Your lawyer can also review your plan to make sure it is up to date with current regulations. For specific questions about ISOs for your company, talk to an employment law attorney.