Incentive Stock Options (ISOs)

Key Provisions

• Employee may buy stock at a specified price (not less than FMV) for 10 yrs
• Options may be exercised in any sequence
• Annual value of ISO exercisable by an individual cannot exceed $100,000/yr
• Appreciation from grant to sale qualifies for capital gains
• Stock must be held for at least 1 yr. after exercise. and 2 yrs. after grant
• Satisfies the conditions of the Internal Revenue Code Section 422 for preferential tax treatment.
• No tax on the option spread at exercise
• Employee pays capital gains tax rates, rather than ordinary income tax rates.

Tax Impact on Employee

• At grant - no tax
• At exercise - no tax assuming holding requirements are met
• At sale - appreciation from grant price taxed at capital gains rate
• Employee realizes no income upon its receipt or exercise.
• Opportunity to pay capital gains taxes on the gain.
• In the event of disqualifying disposition, gain becomes part of annual compensation.
• In order for the employee to receive positive tax treatment, the following requirements must be met:
  • Only employees may receive ISOs.
  • Must hold the shares for two years after grant date and one year after exercise date.
  • Shareholders must approve a written plan specifying the number of shares and class of eligible employees.
  • Option cannot be less than 100% of FMV.
  • Grant value of options that may be exercised for the first time in one year is limited to $100,000 per person.

Tax Impact on Company

• At grant - no tax deduction
• At exercise - no tax deduction
• At sale - no tax deduction unless executive fails to meet holding requirements

Advantages

• No charge to earnings
• Executive's tax liability is deferred until stock is sold
• Long exercise period allows executive flexibility and can be retentive
• Executive may defer taxes or at earlier sale file a disqualifying disposition
• Employees share in the appreciation and the value of the stock.
• Plan can be tailored to benefit particular employees.

Disadvantages

• Executive investment required
• Company loses tax deduction
• Spread at exercise is considered tax preference income for purposes of computing alternative minimum tax
• Executives with 5% plus ownership must pay 10% above FMV
• Dilutes EPS

What does this mean for THE COMPANY?

1. THE COMPANY can provide employees with an opportunity to share in the future success measured by an increase in stock price.
2. The value of stock options does not have to be recognized on THE COMPANY's books, although it must be footnoted to the financial statements. (In effect, ISOs are free from an accounting perspective.)
3. The cost of the stock grants and the tax implications that affect the grants may be predetermined.
4. THE COMPANY will not receive a deduction upon the exercise or qualifying disposition of shares by the employee.
5. THE COMPANY employees with 5% or more ownership must have option price 10% above FMV.

KEY PROVISIONS	TAX IMPACT ON EMPLOYEE	TAX IMPACT ON COMPANY	ADVANTAGES	DISADVANTAGES
Employee may buy stock at a specified price (not less than FMV) for 10 years Options may be exercised in any sequence Annual value of ISOs exercisable by an individual cannot exceed $100,000/year Appreciation from grant to sale qualifies for capital gains Stock must be held for at least 1 year after exercise and 2 years after grant	At grant - no tax At exercise - no tax assuming holding requirements are met At sale - appreciation from grant price taxed at capital gains rate	At grant - no tax deduction At exercise - no tax deduction At sale - no tax deduction unless employee fails to meet holding requirements	No charge to earnings Employee's tax liability is deferred until stock is sold Long exercise period allows employee flexibility and can be retentive Employee may defer taxes or at earlier sale file a disqualifying disposition · Company can select participants	Employee investment required Company loses tax deduction Spread at exercise is considered tax preference income for purposes of computing alternative minimum tax Employee with 5% plus ownership must pay 10% above FMV Dilutes EPS

To find out more on how Compensation Resources, Inc. can help your company with Incentive Stock Options (ISOs), please contact us or call us directly to speak with our compensation consultants at 877-934-0505.