1. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company1 A tax-favored plan for compensating executives by granting options to buy company stock If ISO meets IRS requirements, executive is taxed only when stock sold What is it?

2. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company2 For executive compensation in larger corporations NOT appropriate for closely-held corporations When is it Indicated?

3. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company3 1.greater tax deferral for executive than nonstatutory stock option 2.income from sale of stock obtained through exercise of ISO may be eligible for preferential capital gain treatment 3.little to no out-of-pocket cost to company Advantages

4. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company4 1.Granting corporation does not usually get tax deduction at any time 2.must meet complex technical requirements 3.ISO exercise price must equal or exceed fair market value of stock when option granted 4. executive must have cash to exercise option 5.executive may incur alternative minimum tax (AMT) liability when ISO option exercised Disadvantages

5. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company5 1.Executive is not subject to federal income tax on an ISO when option granted or exercised; taxes deferred until disposition of stock 2.To obtain this tax treatment for ISOs numerous requirements must be met Tax Implications

6. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company6 To obtain special tax treatment: –options granted in written plan that specifies number of shares to be issued class of employees covered under the plan (no nondiscrimination rules) –only first $100,000 of ISO stock granted to any one employee, which becomes exercisable for first time during any one year, is entitled to favorable tax treatment –options must be exercised within 10 years of grant Tax Implications

7. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company7 To obtain special tax treatment: –person receiving grant must be employed with granting company at all times between grant of option and 3 months before date of exercise –stock acquired by ISO must be held at least 2 years after option granted and 1 year from date stock transferred to employee –no options issues more than 10 years from date ISO plan adopted or approved (whichever is first) Tax Implications

8. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company8 To obtain special tax treatment: –option must not be transferable (except by will or descent and distribution) an exercisable only by person receiving it –corporate stockholders must approve ISO plan within 12 months of time adopted by company board of directors –exercise price of option must equal or exceed fair market value of stock on date option granted Tax Implications

9. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company9 To obtain special tax treatment: –ISA may not be granted to any employee who directly or indirectly owns more than 10% of the corporation unless term of option is limited to not more than 5 yrs. the exercise price is at least 100% of the fair market value of the stock on date of the grant Tax Implications

10. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company10 3.Excess of stock’s fair market value over option price at time of exercise is included in individual’s alternative minimum taxable income 4.if stock held 2 yrs. after grant and 1 yr. after exercise, gain on sale taxed at long-term capital gain rates Tax Implications

11. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company11 5.If stock sold before 2 yr. / 1 yr. holding period, excess of fair market value over exercise price is treated as compensation income 6.Corporation gets –no tax deduction for granting ISO –no deduction when option exercised or stock acquired under ISO sold –a deduction for compensation element if stock sold before 2 yr. / 1 yr. holding period Tax Implications

12. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company12 1.A nonstatutory stock option provides greater tax deferral than an ISO. 2.An executive must have cash to exercise an incentive stock option. 3.An executive is not subject to federal income tax on an ISO when the option is granted or exercised. True or False?

13. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company13 4.The special tax treatment of ISOs are automatic, no further rules must be met. 5.A granting corporation does not get a tax deduction for granting an ISO. True or False?

14. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company14 Executive I. M. Best is covered under his company’s ISO plan. The plan grants Best an option in 2009 to purchase company stock for $150 per share. In February 2011, Best exercises this option and purchases 100 shares. Fair market value of the 100 shares in February 2011 is $20,000. Suppose Best sells the 100 shares in December 2011 for $25,000. a.What is Best’s taxable gain? b.How much is treated as compensation income in 2011? c.How much is treated as capital gain? Discussion Question

15. Chapter 36 Employee Benefit & Retirement Planning Incentive Stock Options (ISOs) Copyright 2011, The National Underwriter Company15 Executive I. M. Best is covered under his company’s ISO plan. The plan grants Best an option in 2009 to purchase company stock for $100 per share. In January 2011, Best exercises this option and purchases 100 shares that have a h a fair. Fair market value of the 100 shares in February 2009 is $20,000. Suppose Best sells the 100 shares in December 2009 for $25,000. a.What is Best’s taxable gain? b.How much is treated as compensation income in 2009? c.How much is treated as capital gain? Discussion Question