What are ISOs?
The main tax benefits of incentive stock options are that the option holder can:
(1) delay his or her personal taxable event until the stock is actually sold by the holder (instead of at the exercise of the option), and
(2) receive long-term capital gains treatment for taxable gain at the stock sale (instead of ordinary income tax rates).
In order to receive the tax benefits of ISOs, the startup and stock option holder must comply with various rules. The main requirements are:
ISO Recipient
Only employees of the startup can receive ISOs.
Continuous Employment
The employee must remain continuously employed with the startup for the period from the date of the ISO grant until 3 months before the date of an ISO stock option exercise.
Stock Option Plan
The ISO must be granted pursuant to a written stock option plan. Additionally, the grant must take place within 10 years from the date the stock plan is either adopted or approved by the startup’s shareholders.
ISO Option Length
An ISO cannot be exercised more than 10 years after its grant. (See “Special Rules” below)
ISO Exercise Price
The exercise price for an ISO must be set at FMV (or higher) of the startup’s stock subject to the ISO grant. (See “Special Rules” below)
Nontransferable ISO
ISOs must be nontransferable and can only be exercised by the employee. However, if the employee dies, the employee’s heirs or beneficiaries can exercise the ISOs.
ISO Holding Period
The ISO holder can not dispose the startup’s shares within (i) 1 year from the ISO exercise, or (ii) 2 years from the ISO grant. Thus, the earliest the ISO shares can be sold (and receive favorable tax treatment) is 2 years from the ISO grant (not 3 years).
Special Rules for Founder ISO Grants (i.e. to large shareholders)
A ISO grant to a shareholder with more than 10% of the startup’s voting stock must (i) be set at an exercise price at least equal to 110% of the FMV of the stock subject to the option, and (ii) the ISO option may not be exercised more than 5 years after its grant.
Please note that the above list is not exhaustive regarding ISO requirements.
