What is an Incentive Stock Option (ISO)?

An incentive stock Option (ISO) is defined as a type of stock option granted to an employee by an employer which is a form of incentive with income tax benefit. ISO are special stocks that receive special treatment from the Internal Revenue Service. The IRS also refer to stocks of this nature as incentive share options or qualified stock options. When an ISO is exercised, it is subdues to capital gains tax and not ordinary income tax. ISO is granted ONLY to employees.

Why use an Incentive Stock Option?

Employers issue Incentive Stock Option (ISO) to employees as a way of encouraging them to remain with a company and contribute significantly to its growth. Aside from ISO being an incentive to employees, it is also a way of attracting value-adding employees to a company. Employees who have stayed long with a company and have added value are also issued ISO as a form of compensation. In terms of tax treatment, IRS are favorable to employees, the IRS also accord special treatment to these option stocks. Although, ISO have many benefits, the only downside is that when issued to an employee, the employee has to stay in the company for a number of years in order to benefit from ISO.

How Incentive Stock Options Are Used

Companies do not just give ISOs to employees, rather, these types of stock options are granted to employees that have the potential of adding great value to the company and are required to stay longer to contribute to the companys growth. Incentive stock options give employees that right to buy a portion of the company's share at a predetermined date and price. When ISOs are issued, they carry a grant date, this is the day when ISO can be exercised by employees. ISOs are taxed by the IRS based on the variance in price of when the stocks are exercised and the price when they were granted. Also, the gains accrued by employees at the sale of these stocks are taxed under capital gains rate and not as ordinary income tax.