Tax planning and compliance for investors
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First page of our online guide to incentive stock options.
Incentive stock options (ISOs) are a form of equity compensation that provides unique tax benefits — and significant tax complexity. In recent years their popularity has grown to roughly match the popularity of nonqualified stock options.
Nonqualified options have two disadvantages compared to incentive stock options. One is that you have to report taxable income at the time you exercise the option to buy stock, and the other is that the income is treated as compensation, which is taxed at higher rates than long-term capital gains. Incentive stock options provide a way to avoid both of those disadvantages. There's no income to report at the time you exercise the option (unless you sell the stock at the same time you buy it). And if you hold the stock long enough to satisfy a special holding period, your gain from the stock will be treated as long-term capital gain.
These tax advantages are partly offset by the alternative minimum tax (AMT). This is a complicated calculation that may cause you to pay tax at the time you exercise an ISO. But the amount of AMT you pay is less than the tax you would have paid if you exercised a nonqualified option — and you may be able to recover much or all of the your AMT payment by claiming an AMT credit in future years.
Incentive stock options must be granted pursuant to a stock option plan that was adopted by the company's board of directors and approved by the shareholders. The board of directors, or a committee appointed by the board (usually called the compensation committee), may decide who receives the awards and the specific terms of the options. In some cases options are granted according to a formula.
When a company grants an option it should provide certain documents. You should receive an option agreement, setting forth the specific terms of your option, and a copy of the plan, which provides some general rules that govern all options. In many cases the company also provides a summary of the plan.
It's important to understand your rights under the agreement and the plan. You need to know:
Make sure you keep these documents in a safe place. Be sure to review them from time to time for planning purposes. At a minimum, you want to think about your options before the end of each year to determine whether to exercise some or all of the options by December 31 as part of your tax planning.
Here are some of the important terms used in connection with nonqualified options:
Companies have some flexibility in the terms they can offer for incentive stock options. Your option may differ from the typical option in a number of important ways. But it may be helpful to compare your option with the norm:
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