Clients frequently ask if they can provide incentive compensation to their employees and executives in a manner that gives them flexibility and drives performance, but receives coveted capital gains treatment. This usually sounds too good to be true. In most cases, you can defer or sometimes minimize income tax for employees (retirement plans, deferred compensation arrangements, stock appreciation rights, non-qualified stock options), but there is one tool that enables employees to skip income tax, FICA, and withholding altogether – well-designed and-well managed incentive stock options or “ISOs.”
Incentive stock options – sometimes called statutory options because they are established and governed by Internal Revenue Code 422 – are a kind of stock option that can provide “special” tax treatment to the recipients if certain requirements are satisfied. There are two key differences between incentive stock options and their more common cousin – the non-qualified stock option:
What is AMT? At a very high level, the Alternative Minimum Tax (AMT) is simply an alternative tax structure to the more well-understood and more often used regular income tax method. In order to determine which tax to apply, taxpayers must calculate taxes under the regular income tax method and the alternative minimum tax and then pay whichever amount is greater. This does not come up particularly often for most normal taxpayers, but is relevant for most ISO recipients because the value of the spread at exercise is not taken into account under the regular tax method, but it is considered as a preference item in the AMT method. The larger the spread, the more likely ISOs will trigger the AMT.
The flipside is that ISOs are less tax advantageous to employers because, if all goes as planned, they will never be permitted to take a deduction for the compensation. However, because the corporate tax rate was reduced with the Tax Cuts & Jobs Act, some employers are taking a second look at whether to issue ISOs now, considering that the deduction is now less valuable.
To receive this special treatment, the plan document, award agreement, and management of the incentive stock option award must meet certain requirements:
Plan and Award Agreement
Eligibility and Operation