As with every aspect of business, there are pros and cons to establishing an incentive stock option plan; but before one can even make the decisions necessary, it is important to understand what an incentive stock option plan is. The incentive stock option plan (“ISO”) is part of a deferred compensation plan which companies offer to their employees and allows those employees to purchase shares of the company’s stock at discounted prices in the future. These plans differ from normal stock purchase plans because they are generally offered only to top-tier management or key employees, as opposed to all employees. Employee Stock Options Plans, U.S. Securities and Exchange Commission, sec.gov.

For purposes of Federal Income Tax treatment, 26 U.S.C. Section 422 defines an ISO as: “an option granted to an individual for any reason connected with his employment by a corporation, if granted by the employer corporation or its parent or subsidiary corporation, to purchase stock of any of such corporations, but only if—

            (1)        the option is granted pursuant to a plan which includes the aggregate number of shares which may be issued under options and the employees (or class of employees) eligible to receive options, and which is approved by the stockholders of the granting corporation within 12 months before or after the date such plan is adopted;

            (2)        such option is granted within 10 years from the date such plan is adopted, or the date such plan is approved by the stockholders, whichever is earlier;

            (3)        such option by its terms is not exercisable after the expiration of 10 years from the date such option is granted;

            (4)        the option price is not less than the fair market value of the stock at the time such option is granted;

            (5)        such option by its terms is not transferable by such individual otherwise than by will or the laws of descent and distribution, and is exercisable, during his lifetime, only by him; and

            (6)        such individual, at the time the option is granted, does not own stock possessing more than 10 percent of the total combined voting power of all classes of stock of the employer corporation or of its parent or subsidiary corporation.

Such term shall not include any option if (as of the time the option is granted) the terms of such option provide that it will not be treated as an incentive stock option.”

In the ISO, stock to be sold is issued on a beginning or “grant date,” and the offering period is always ten years (unlike the normal stock option plan). (See 26 U.S.C. Section 422(2) and (3)). Once the employee exercises its option to purchase the shares, the employee can then sell those shares immediately (presumably for a profit) or hold them for some period of period of time. So long as any sale of the shares occurs at least two years after the grant date and at least one year after the exercise date, any sale of the shares results in capital gains taxes to the employee, as opposed to any gain on the sale being taxed as ordinary income. Most ISOs also contain a vesting schedule which must be met before the employee is permitted to exercise its option. To exercise the right to purchase under any type of ISO, the plan can be structured so that to exercise the option, the employee either pays a cash price for the shares or acquires them through a cashless transaction where the employee funds the purchase through deductions from other income.

In theory, a properly structured ISO can allow a company to reward its key employees by offering shares of its stock tied to the employee’s performance and the overall performance of the company. After exercising the option, the employee is rewarded by the ability to sell the shares of the company at a greater price that the employee paid at the time of the exercise of the option (because the price of the stock presumably has risen). To prevent an employee from simply exercising its option to purchase then leaving the company, another component of the properly structured ISO is a provision that allows the company to recall the shares if the employee leaves the company for any reason other than death, disability, or retirement, or if the company experiences a financial set-back.

While there are a number of reasons to use the ISO, there are also a number of reasons that they may not be appropriate for your business. These disadvantages include, but are not necessarily limited to:

• When one of the key employees exercises the option, a new owner of the enterprise emerges. The new owner(s) now is in a position to analyze the business and its operations.
• Potential purchasers of the business are hesitant to pursue deals where a number of small stock options and minority shareholders exist.
• The company may face adverse tax advantages.
• When times are good, the options are appealing, but when the options are exercised times, may not be so good, thus creating a perception of an empty promise by the very employees the company sought to reward at the time the plan went into effect.

Stock Options: Top 5 Reasons NOT to Use Them as an Employee Incentive, Steve Parrish, Forbes.com, Feb. 20, 2013.

If you would like to arrange for a consultation to discuss whether you should use an ISO to attract and keep key employees, or if you would like to discuss any other employment or business-related matter with a rising star, Michael Leonard, Esq. of San Diego Corporate Law should be your first call. He has the experience and knowledge to ensure all of your business agreements are enforceable in the California Courts. He can be contacted by visiting San Diego Corporate Law or by telephone at (858) 483-9200.