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Lesson 5. Incentive Stock Options > Exercise Price - Pg. 22

Incentive Stock Options 22 Holding Period The holding period for ISOs is one of the most critical tests for tax-favored treatment. These rules fix a certain holding period for stock from the ISOs and that makes them attractive to employers that want to keep top employees motivated to stay with the company. The general rule is the employee must hold the stock from an ISO for at least one year from the exercise date. The current tax code sets one year as the minimum holding period to qualify for long- term capital gains rates. The employee must also hold stock from an ISO for two years from the grant date. These two requirements mean the earliest an employee could sell stock bought through an ISO is two years after the grant date. Important Dates Here are some dates to keep track of: · You must hold stock from an ISO at least one year and a day from the exercise date. · You must hold stock from an ISO for two years from the grant date. A schedule that considers these two dates reveals the earliest time the stock can be sold and qualify for favored tax treatment. Here's how it looks: Grant Date Jan. 1, 2000 Exercise Date Jan. 1, 2001 Qualifying Sale Jan. 1, 2002 In this case, the employee exercises the option immediately, but must hold the stock for two full years to meet the holding requirement. Since an ISO's exercise price must equal or exceed the fair market value of the underlying stock on the grant date, this scenario is unlikely. Tip Incentive stock options are rarely exercised when granted because they are issued at fair market value of the underlying stock. It would not make much sense to exercise at this point. Let's look at another example: Grant Date Jan. 1, 2000 Exercise Date June 1, 2001 Qualifying Sale June 2, 2002 In this example, the employee chooses not to exercise the ISO until June 1, 2001. The earliest possible qualifying sale date is one year and one day past the exercise date, since the two-year holding requirement from grant date is met on January 1, 2002. If these holding periods are not met, the ISO automatically becomes a nonqualified stock option and the employee will owe ordinary income tax on the difference between the exercise price and the fair market value of the stock at exercise. Top personal income tax rates at the time of this writing were 39.6 percent and long-term capital gains rates are 20 percent. A miscue on the timing could cost the employee twice the tax bite. Exercise Price The tax code says the exercise price can't be less than 100 percent of the fair market value of the underlying stock.