Incentive Stock Options Pros and Cons

An incentive stock option is a corporate benefit that gives an employee the right to buy shares of company stock at a discounted price with the added benefit of possible tax breaks on the profit. The profit unqualified incentive stock options is usually taxed at the capital gains rate and not at the higher rate for ordinary income. Does your company offer incentive stock options? Are they good or bad? Can they benefit you financially long term? What are the pros and cons of incentive stock options?

ISO or incentive stock options are sometimes combined with RSU’s or restricted stock units. Both are reserved for highly valuable members and employees of a certain company that most employers want to retain. If you are offered these types of stock options, know that you are very valuable and of the company is definitely looking to retain you long-term.

The main difference between these two is that RSU’s result in some amount of income upon vesting where incentive stock options are a little more complicated. Each of these has its own time allotment, typically at the end of four years where the grant is fully vested.

Employee stock purchase plans or ESPP are also stocks involved in qualifying dispositions traditionally acquired through an employee. Both are used by companies to attract and retain talented personnel and ESPP requires shareholder approval before it’s implemented where incentive stock options or ISO can be implemented from the employer alone.

Pros and cons to incentive stock options (ISO)

Often referred to as equity compensation, ISO offers equity in a company in lieu of cash payments or paychecks. This could include restricted stock bonus purchase plans, incentive stock options or ISO’s, and nonqualified stock options. Stock purchase plans may also be available. ISOs or incentive stock options are options in a company stock meeting the requirements of IRC §422 concerning a written plan, term limits, the price, the employment at the time of grant, employment at the time of exercise, limit on option value, restrictions on transfer, and holding periods. The advantage of incentive stock options is the favorable tax treatment for employees. The disadvantage is the statutory requirements and the lack of any deduction for the company. These can be quite constrictive.

ISOs are a popular measure of employee compensation granting rights to a company stock at a discounted price at a future date. The biggest advantage is increased productivity from the employee, strengthening the succession pipeline, and encouraging retention. If an employee has skin in the game, so to speak, they’re more likely to do better on the job increasing their own profits.

Disadvantages to ISOs could be encouraging deception, misaligned incentives, and can lead to conflict over time. Result-driven incentives can sometimes get out of control when employees find that their current level of performance is not sufficient to achieve the incentive milestones. Positive incentives may actually become negative as employees look for ways to make their performance appear to be good even though the actual results are not in line with the incentive goal.

Misaligned incentives can also be negative. Properly designed incentive programs can encourage and reinforce behavior that will contribute to sustainable success but a poorly conceived program could incentivize people into risky and irresponsible behavior. While this is unlikely, it can happen and needs to be considered, especially from an employer’s standpoint.

Finally, incentive stock options can lead to conflict even though most programs are extremely fair stating objectives that anyone in the company could potentially reach. Incentive stock options are a slippery slope for some types of companies.

Should you accept incentive stock options?

Typically an ISO will make up for some normal paycheck compensation or salary compensation. It’s always a good idea to accept as the level of income could be limitless depending on how the market goes, after all, you have nothing to lose. However, if you prefer money in your pocket at the time of payment, a steady paycheck without the ISO attached might be the best option. If the company is at risk at all, the option could become worthless but, if it does not hinder your monthly paycheck, participating in an ISO could be beneficial for everyone involved.

Every single company and employee is different so what works financially for one may not work for another. The best way to determine the options that are right for you is to sit down with a financial planner and discuss options and the future benefits and disadvantages. Contact Chrome Advisors today for more information on incentive stock options and whether they work for your situation and your future financial gain.

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