CFO Corner: Equity Compensation – The Ups and Downs of ISOs

Stickman ups and downs of isos
Incentive Stock Options are a great place to start talking about equity compensation. ISOs are “appreciation-only” vehicles, meaning they have direct value to employees only if the stock price appreciates above the initial grant price. Other common appreciation-only instruments include NQSOs and SARs (to be covered in future posts). If you understand ISOs, you can easily understand other appreciation instruments.

By now most compensation professionals know that stock options are a tool with built-in cost (usually the stock price on the grant date) for the participant. They are almost always subject to vesting schedules and are powerful tools that may be very beneficial when conditions are right, but dangerous if used incorrectly.

ISOs are a special kind of stock option. They were created to provide income and tax advantages. IRC 421, 422, 423 and 424 provide a rule set for ISOs other forms of tax-qualified equity. ISOs are defined mainly in IRC 422. So, what makes ISOs so special?

  1. ISOs offer the ability to exercise options without an immediate income event.
  2. They allow individuals the potential to avoid ordinary income and associated taxes altogether.
  3. They require no Medicare or Social Security taxation and withholding (or the matching company payment.

ISOs require specific plan provisions and grants must adhere to a restrictive rule set. The plan may only allow for new ISO grants for a period of 10 years. The plans must also specify the aggregate number of shares that can be granted as ISOs. The grants cannot be priced below the Fair Market Value on the grant date (and 100% of the FMV for individuals who own 10% or more of the company.) They can only be granted to employees (full or part-time.) The grants must expire in no more than 10 years (5 years for the 10% shareholders.) The value of ISOs for an individual cannot exceed $100,000 in exercisable ISOs in any calendar year. In order to obtain the preferential tax treatment, exercised shares must be held for at least two years from the date and grant and 1 year from the date of exercise (if these periods are met then the eventual gain is treated as capital gain/loss rather than ordinary income). That’s enough boring rules for now….

Even with these restrictions most employees would much rather receive ISOs than NQSOs. The benefits outweigh the downsides. And, there are significant downsides to both the individual and the company.

  1. The spread at the time of exercise is an AMTI preference item, meaning that an individual may owe tax on ISOs they have held for the holding period benefit.
  2. Unlike NQSOs where it is guaranteed, the company cannot plan ahead in expectation of the corporate tax deduction that comes with ordinary income.
  3. ISOs, like any appreciation instrument, may not have exercisable value when they finally vest. The stock price must be higher than it was at grant.

ISOs are most commonly seen in pre-IPO start-ups where the potential of stock price increases are high (as long as the company is successful) and the gains are large enough to make holding the stock for capital gain treatment enticing.  They are still very common for executive compensation programs. Executives generally have the investment knowledge and advice required to make good decisions about the somewhat complex tax planning opportunities. One place they have melted is in broad-based programs at small and midsized public companies. This is mainly due to the fact that few employees take advantage of the ISO upsides while all companies are hit but the ISO downsides.

Incentive Stock Options are an incredibly useful tool in your compensation toolbox. Proper plan design, education and planning can reduce most of the negatives, while augmenting the positives. They are not a cure-all or silver bullet, but used intelligently can provide an impact that cannot be attained with any other type of compensation.

This post is part of a series of posts on equity compensation instruments that will run the first Thursday of every month for the foreseeable future.  As always, you can reach out to me directly.

Dan Walter is the President and CEO of Performensation an independent compensation consultant focused on the needs of small and mid-sized public and private companies. Dan’s unique perspective and expertise includes equity compensation, executive compensation, performance-based pay and talent management issues. Dan is a co-author of “The Decision Makers Guide to Equity Compensation”, “If I’d Only Know That”, “GEOnomics 2011” and “Equity Alternatives.” Dan is on the board of the National Center for Employee Ownership, a partner in the ShareComp virtual conferences and the founder of Equity Compensation Experts, a free networking group. Dan is frequently requested as a dynamic and humorous speaker covering compensation and motivation topics. Connect with him on LinkedIn or follow him on Twitter at @Performensation and @SayOnPay

 

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