You have just been hired on as an executive at SmallCorp, Inc., and in your employment agreement you see the following:
“Executive shall be granted an option to purchase 500,000 shares of SmallCorp, Inc.’s common stock at $0.10 per share for 3 years.”
What is this and what does it mean for you?
Incentive Stock Options (“ISOs”) (also referred to as “Qualified Options”) are privileges granted to employees of a company under which qualifying options are free of tax at both the date of grant and exercise. This means you will not have to pay the taxes incurred as a result of this grant until you sell the shares. ISOs must meet the requirements of tax Code Section 422 of the Tax Reform Act of 1986.
To have your option to purchase 500,000 shares eligible for treatment as an ISO the following must be true:
• An ISO may only be granted to an employee of the company, or its subsidiary;
• the 500,000 shares must be granted pursuant to a written plan that specifies 1) the total number of shares that may be issued under options and 2) the employees or class of employees eligible for grants under the plan;
• the written plan must be approved by company shareholders within 12 months before or after the plan is adopted by the company Board of Directors;
• The maximum exercise period must not exceed 10 years. But, if the executive eligible under the plan owns more than 10% of the total combined voting power of all the classes of stock in the company, the maximum exercise period for that executive cannot exceed 5 years;
• An ISO cannot be transferable by the optionee during the optionee’s lifetime;
• The exercise price of the option cannot be less than the Fair Market Value on the date of grant. But, if the executive owns more than 10% of the total combined voting power of all classes of stock in the company, the exercise price cannot be less than 110% of the Fair Market Value on the date of grant;
• You, the executive, may not sell shares purchased under an ISO within 2 years from the date of grant, or within one year from exercise;
• You may not be granted ISOs that have an aggregate Fair Market Value that exceeds $100,000 during the calendar year when the options are first exercisable;
• Upon termination of employment, you must exercise the option within three months;
If for any reason one of the above requirements are not met, your option to purchase 500,000 shares will not be treated as an ISO, but as a Non-Qualified Stock Option. This means that generally, the options are taxed at the time of exercise.
There are obviously other considerations specific to each company and individual, so contact your attorney to discuss your specific facts.