What is the Incentive Stock Options (ISO)?
Incentive Stock Option (ISO) refers to the option which the company gives to its employees. It allows them to purchase the stock of the company at a price which is lower than the prevailing market price. This technique is used by many companies to retain their top employees for the long run.
- There are two dates which we need to consider. One is the date on which such an option is made available for exercising to the employees, i.e., grant date. And the other is exercise date, the date on which the employee purchased the stock exercising the option given to them.
- The above option given to employees is for a particular period, which has a maximum duration of three years. I.e., if the option is made available for exercising on 01.04.2020, then it could maximum be open till 31.03.2023.
- The employees of the company could purchase the stock using cash or through a stock swapStock SwapA share swap occurs when one equity-based asset is exchanged for another equity-based asset. This is common in acquisitions and mergers. When a share swap is initiated, the share values of both companies are accurately priced to determine the fair swap ratio..
- The options given are with some terms and conditions from the point of retaining the employees for the company. The company does this to utilizes the skills of such employees to the benefit of the company.
How does the Incentive Stock Options Works?
- The company gives an option to the existing employees of the company for purchasing a certain number of stock at a specific predetermined price after meeting the fixed eligibility criteria.
- If the employees purchase them, then they need to behold by such employees as per the vesting period.
- These types of options are generally given by the companies whose stocks are traded publicly or, in other words, say by public limited companies.
- Companies sometimes issue these as a prerequisite to the employees for their continuous gratitude towards the organization.
When is Incentive Stock Options Taxed?
The stock optionsStock OptionsStock options are derivative instruments that give the holder the right to buy or sell any stock at a predetermined price regardless of the prevailing market prices. It typically consists of four components: the strike price, the expiry date, the lot size, and the share premium. granted do not have the implication of taxes at the time of their allotment or at the time of exercising. Taxation of these is in the manner as other capital profits and at the same tax rate as capital gains. The question and impact of taxability arise at the time of their sale by the stockholder. The fair market value of option exercised on the date of exercising the option will be subtracted from the sale value of a stock to compute the capital gain earned and applicable taxes.
- The government gets some amount as taxes from the persons selling such options after meeting the conditions laid upon at the time of exercising the option.
- These types of options help both the employer as well as employee. The employer gets surety of their employee retained, and the employee will save some amount of money in the long run.
Advantages of Incentive Stock Options
- Under this method, the company gives its employees an opportunity to have ownership in the stock of the company in which they are working.
- It helps in creating long term savings for the employees of the company apart from their salaries, which they have to spend on living their livelihood as well.
- Used as a saving strategy for employees of the company. It becomes challenging for employees to save from the salary which they regularly get;
- It also may result in far high capital appreciationCapital AppreciationCapital appreciation refers to an increase in the market value of assets relative to their purchase price over a specified time period. Stocks, land, buildings, fixed assets, and other types of owned property are examples of assets. to the employees, which they could not achieve.
- There are no taxes till the sale of such stocks which they have purchased using such an option.
- It will affect the prevailing market price adversely. The existing stockholdersStockholdersA stockholder is a person, company, or institution who owns one or more shares of a company. They are the company's owners, but their liability is limited to the value of their shares. who have purchased shares from the open market will tend to make negative makeup about the company.
- As the number of stockholders increases, the financial position of the company got affected as EPSEPSEarnings Per Share (EPS) is a key financial metric that investors use to assess a company's performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is. and Diluted EPSDiluted EPSDiluted EPS is a financial ratio to check the quality of the Earnings per Share after taking into account the exercise of Convertible Securities like Preference Shares, Stock Option, Warrants, Convertible Debentures etc. of the company will fall.
Incentive Stock Option is linked with retaining the employees of the companies. Nowadays, it becomes tough for the business to retain trustworthy and experienced employees. So this is a method used by the companies whose workings are mainly dependent upon the employees of the company; or who have the ideology of retaining experienced employees working with the company for long. The company gives them some sort of temptation for retaining them and enjoying their services for some more years.
This article has been a guide to what is Incentive Stock Options and its definition. Here we discuss how does ISO works, its characteristics, along with advantages and disadvantages. You may learn more about financing from the following articles –