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Chapter 15. Shopping at the Company Stor... > Stocking the Shelves with ISOs, NSOs... - Pg. 153

Shopping at the Company Store 153 ISOs An ISO is an incentive stock option: a contract that gives employees the right to purchase shares of company stock sometime in the future at the currently established price set by the company. The option limits the number of shares you may purchase-- usually to 100 share lots. Stock options do not cost the employer anything when they offer them to the employee. They are often granted as part of the employment package for new employees and to keep seasoned employees who may want to jump ship. ISOs are shareholder-approved plans that limit the value of options that an employee can exercise in one year to $100,000. There can also be other limiting factors in the plan, such as limiting the option term to 10 years. The option price is fixed according to a formula or to the fair market price on the day the option is granted. Companies offer options as a way of rewarding employees. So, again, if there's a carrot dangling out there, they will make it hard to get. The contract will tell you how far into the future you must wait before you can purchase the shares. If there wasn't a time frame attached to the option, you could jump ship as soon as the stock took off. And if you do jump ship, most companies will not allow you to keep those options forever; you have to exercise them within days of leaving the company. After all, the incentive in offering you a piece of the action in the first place is to keep you as an employee. Warning! If you are a highly compensated individual (and sometimes even if you're not), the alternative minimum tax (AMT) may kick right in. This can throw a wrench into your plans. When exercising an ISO, there is an item of adjustment for AMT purposes. Check it out with your tax advisor before exercising an option, not afterward. For example, let's say that you have just started to work for the Widget Company. As part of the employment package, you are given stock options to purchase up to 500 shares of the Widget Company in the future at today's market price of $10 a share. A year later, the price is up to $30 a share. You decide to exercise part of your option and buy 200 shares at the agreed-upon price of $10 a share. You paid $2,000 for the shares, but the market value is $6,000. No income taxes will be due until you sell the shares. If you turn around and sell them the next day, the gain of $4,000 is treated as ordinary income (which could be as high as 39.6 percent) for tax purposes. According to the IRS Code section 422, if you hold the shares acquired through an ISO for at least two years from the date of the grant and for at least one year from the date of exercise of the grant, you pay tax at the long-term capital gains rate. (We know that sounds a little complicated, so read the sen- tence a couple more times--that's tax law for you.)