What are Incentive Stock Options?

Also known as ISOs, incentive stock options are opportunities to acquire shares of stock through an employer. Incentive share options of this type may come in the form of a retirement plan, or as part of a merit-based incentive that is earned by compliance with a proscribed set of standards. In the United States, incentive stock option plans sometimes come with tax benefits, depending on how the stock option program is configured.

Incentive stock options are one of several employee stock option offerings. Non-statuary stock option plans, as well as non-qualified stock option plans, do not carry the same tax benefits. At the same time, these types of stock option plans also provide less of an opportunity for earning a return, a factor that may be attractive to some employers as well as employees who tend to favor conservative investment schemes.

With incentive stock options, there is a greater degree of volatility involved, since the stocks included in the plan are likely to carry a higher rate of risk. In return for taking on this additional risk, the returns on the investment are usually higher. When coupled with the tax benefit, this type of option incentive has the capability to create a solid nest egg for the employee.

In the United States, the main tax benefit of incentive stock options is that ordinary income tax is not assessed on the difference between the fair market value of the acquired stock and the exercise price. Depending on the structure of the plan, the investor may have to pay a lower tax assessment, known as the alternative minimum tax. In return for this tax break, the holder must retain control of the shares for at least one calendar year from the date of exercise, and two years from the date that the shares are granted to the holder. If the shares are sold, any profit that is made by the sale of the shares will be subject to that lower alternative minimum tax.

The concept of incentive stock options is not unique to the United States. Over the years, companies based in the United Kingdom, France, Canada, and various Asian and South American countries have offered similar programs. Most of the models used around the world do include some type of tax benefit, such as deferring the assessment of taxes until the holder sells the shares and thus profits from the transaction.

In recent years, some companies have opted to expand the offering of incentive stock options from officers only, allowing salaried employees to also participate in the plan. This is particularly true when the incentives are used as a substitute for a pension or other form of retirement plan. Depending on the performance of the stocks involved, a plan of this type does exhibit the potential to provide a comfortable source of income during the retirement years.