Share Equity, Inspire Excellence: What Are Incentive Stock Options?

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Competitive salaries are just one part of a strong compensation strategy. To attract and retain top talent, especially in competitive industries, employers often need to offer additional incentives that support long-term engagement.

Incentive stock options (ISOs) are a type of equity-based compensation that companies can offer to help lower turnover rates and promote loyalty. By providing employees a stake in the company's success, employers signal shared ownership that supports morale and encourages a long-term perspective on employment.

Although ISOs are a compelling addition to a rewards strategy, employers need to consider nuances like tax implications before adding them to benefits packages. Learning what well-designed incentive stock options are can elevate a compensation package, but a poorly structured plan may create unnecessary confusion and unintended costs. Here’s what you need to know to decide if ISOs are a good choice for your company

What is an incentive stock option?

ISOs are an alternative form of compensation that gives employees the right, but not the obligation, to purchase company stock at a predetermined price, known as the “strike price.” Rather than receiving shares outright, employees are granted the option to buy shares in the future, typically after meeting conditions outlined in a vesting schedule.

Unlike some other forms of equity-based compensation, ISOs have one of the more favorable tax treatments under the Internal Revenue Code, since gains on ISOs qualify for long-term capital gains taxes rather than being taxed as ordinary income (which usually offers a more favorable tax rate, though this depends on individual tax situations).

Typically, ISOs are a strategic addition to a company's retention strategy. By providing employees the opportunity to have a stake in the company's growth, ISOs may encourage long-term commitment and performance, fostering a sense of ownership and shared success.

How incentive stock options work

Companies set the terms of an ISO agreement and communicate them to eligible employees. While plan details can vary by company, here’s a breakdown of the four core stages.

1. Grant

On a "grant date," the company formally issues a specific number of ISOs to an employee and sets the terms of their agreement. This is when the strike price and vesting schedule is defined so that employees know the price at which they can purchase shares and exercise these options. The grant doesn't cause any immediate tax consequences or ownership — it represents a potential future opportunity to purchase equity if employees follow the eligibility requirements.

2. Vesting

ISOs are usually subject to a vesting schedule, meaning employees must remain with the company for a certain period before gaining the right to exercise their options. Many schedules often involve a "cliff" during which no options vest, followed by incremental vesting that occurs monthly, quarterly, or yearly, depending on the company’s vesting policy.

A common vesting schedule is a four-year vesting with a one-year cliff. For example, an employee granted 1,000 ISOs on January 1 would have 25% of their options (250 shares) vest after one year. After that, the remaining 750 shares would vest in equal quarterly installments over the next three years.

Special considerations

Some companies allow early exercise, which permits employees to purchase options before they are vested. However, employees considering this must file an 83(b) election within 30 days to limit the taxable liability to the difference between the fair market value (FMV) and the strike price. Without filing an 83(b), any increase in value between the exercise date and the vesting date may be treated as ordinary income when the shares vest, even if they don't sell their shares. Because tax implications can be complex and vary by individual circumstances, employees should always consult a qualified tax advisor before making any decisions.

3. Exercise

Once options have vested, employees can "exercise" their ISOs, meaning they can purchase the company shares at the pre-agreed strike price. Exercising doesn’t guarantee profit, but it can give employees equity ownership, which may become valuable over time depending on the company’s performance and market conditions. However, ISOs may trigger liability under the alternative minimum tax (AMT) liability. For this reason, it’s a good idea to speak with a tax advisor before exercising.

Special considerations

Many ISOs include provisions for employees who exit the company with vested shares, known as post-termination exercise windows (PTEWs). The PTEW is the timeframe an employee has to exercise their vested ISOs after leaving the company (typically 90 days). After this period, ISOs expire or convert to non-qualified stock options (NSOs) which carry different tax treatment.

4. Sale

After exercising, employees may choose to sell their shares. For public companies, this usually involves selling on the open market, but employees may still be subject to blackout periods, during which trading is restricted. In private companies, selling shares is often more limited and may require waiting for a liquidity event such as an IPO or acquisition or using company-approved secondary markets, if available.

Whether or not an employee decides to sell depends on multiple factors, including their long-term belief in the company's share price, current financial needs, and tax implications. When an employee sells their shares, they either realize a gain or loss relative to their strike price, and they're subject to taxation, depending on how long they held their shares and the price at the time of sale.

ISO taxation — How are incentive stock options taxed?

Besides offering a greater sense of ownership in a company, ISOs are attractive rewards from a tax perspective. While ISOs are often considered tax-advantaged compared to other stock options, they aren’t tax-free. Employers and employees should review the implications closely and consult a tax professional if needed.

Here are a few of the tax implications and limitations employees should consider.

No tax at grant or vesting. ISOs don’t trigger tax liability when granted or while vesting because no actual income or ownership is transferred at those stages.
Capital gains eligibility. A key tax advantage with ISOs is that they're eligible for more lenient long-term capital gains treatment. To achieve this tax status, employees have to hold their shares for at least one year following the exercise date and two years after the grant date. After meeting both of these conditions, the shares become a "qualifying disposition," and the difference between the sale and strike prices gets taxed at lower, long-term capital gains rates.
AMT implications. Although exercising ISOs doesn't trigger regular income tax, the bargain element — the difference between the stock’s FMV at the time of exercise and the strike price — is treated as income for AMT purposes. As a result, even if employees don't sell shares or realize a cash gain, they may still owe AMT in the year of exercise if the bargain element is significant.
Disqualifying disposition and ordinary income tax. If an employee sells shares before meeting the holding requirements for a "qualifying disposition," they have to pay higher taxes on the sale. In these cases, employees hold "disqualifying dispositions," and the IRS treats the bargain element at the time of sale as ordinary income, taxing it accordingly. Any additional gain beyond the FMV on the exercise date gets taxed as short-term or long-term capital gains, depending on how long employees hold their shares post-exercise.

Due to the complexity of ISOs, employees should consult a qualified tax professional before making any decisions.

ISOs versus NSOs

ISOs aren't the only way to reward employees with stock options. There's another type of equity-based compensation method known as Non-Qualified Stock Options (NSOs) that also offers the right to purchase shares after a vesting period at a predetermined price. While ISOs and NSOs have many similarities, there are legal and tax implications to consider when choosing between them.

Category	ISOs	NSOs
Eligibility	Only for employees	Available for employees,contractors, advisors, and consultants
Grant limits	$100,000 FMV limit per employee per year for favorable tax treatment	No limit on grant amount
Taxation at grant and vesting	None	None
Taxation at exercise	No regular income tax, but the bargain element may trigger AMT	The bargain element gets taxed as ordinary income
Taxation at sale	Depends on whether shares meet holding requirements for qualifying disposition. If so, the entire gain gets taxed as long-term capital gains. If not, the bargain element gets taxed at exercise as ordinary income with any gains taxed as capital gain.	Any gain or loss on the sale is capital gain/loss.
Employer deduction	Only available on disqualifying dispositions	Deduction equal to employee’s ordinary income at exercise
Use case	Could support long-term employee retention and higher morale with potential for more attractive tax savings	Offers more flexible and broader equity compensation, but with lower tax incentives

Empowerment beyond equity: Support financial well-being with EarnIn

ISOs are a powerful way for companies to encourage long-term commitment and align employees with a company’s future success. But while equity offers potential for future gains, it doesn’t address the everyday financial challenges employees may face in the present. For a well-rounded compensation strategy, companies should consider pairing long-term incentives with more immediate financial wellness support.

EarnIn can help you do just that. With no payroll integration required and no cost to employers, EarnIn’s Earned Wage Access solution allows employees to access their pay in minutes, up to $150 per day, with a maximum of $750 per pay period¹, starting at just $3.99 per transfer². Alternatively, employees can choose to receive funds in 1-3 business days at no cost. Tips are optional³.

Beyond earned wage access, EarnIn offers a suite of financial wellness tools to help employees stay financially resilient. Features like free Credit Monitoring⁴ enable employees to track their credit score, while Balance Shield⁵ helps protect against overdraft fees.

By pairing ISOs with accessible, employee-centered financial wellness benefits, employers can create a more holistic and equitable compensation experience. This approach supports both immediate financial needs and long-term wealth-building, making total rewards more meaningful and inclusive for today’s diverse workforce.

Ready to enhance your compensation strategy with financial wellness tools? Schedule a demo with EarnIn today to see how you can support your team.

Please note, the material collected in this post is for informational purposes only and is not intended to be relied upon as or construed as advice regarding any specific circumstances. Nor is it an endorsement of any organization or services.

This Blog was sponsored by EarnIn. While the author received compensation, the information shared is grounded in independent research and intended to provide helpful and accurate guidance to readers.

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