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Stock Options Explained

Companies offer many different types of stock purchase plans and Equity Incentive Plans to their employees as a means of encouraging hard work and providing an incentive to stay with the company. These plans offer either a discount or a tax advantage. Nonqualified stock options are typically offered to all employees of the company, but there are special stock options available for those who have a significant impact on the company's growth.

Incentive Stock Options Explained

Incentive stock options (ISOs) are given only to key employees and top management of the company. Generally, ISOs receive more favorable tax treatment than nonqualified stock options do. So it's often to your advantage to use ISOs to attract and retain key employees.

Incentive stock options must be granted under a written plan document. This document must specify employees who are eligible for the options, and the total number of shares that may be issued. Stockholders must approve of the plan in the 12-month period before or after the plan is adopted.

Options must be granted under an ISO agreement. Written ISO agreements should detail any restrictions on exercising ISOs as well as an offer to sell the stock at the option price and the time period in which the option will be available.

How Stock Options Work

When incentive stock options are exercised, the stock is purchased at a preset price. In some cases, this price is well below the market value. As previously mentioned, there are tax advantages to exercising these stock options. One advantage is that the employees don't have to report income when they exercise their incentive stock option or receive a stock option grant. The only time they are required to report taxable income is when they sell the stock. How the income is taxed will depend on how long the employee owned the stock. Generally, the longer they hold onto the stock, the greater the tax advantage.

Here's how stock options work:

When employees are issued ISOs and exercise their right to buy the options, they have the freedom to either immediately sell the stock or hold onto it for a period of time. The offering period for ISOs is always 10 years. After 10 years, the options are no longer available.

Clawback provisions may be put into place that give you, as the employer, the right to recall the options. For example, if the company is unable to fulfill the obligations of the options financially, the options may be recalled. You may also recall the options if the employee leaves the company for any reason barring retirement, death, or disability.

As an employer, it's not only your job to hire great talent but also to retain them. ISOs are a powerful way to incentivize them to stay and invest their efforts in making your a company a successful one.

This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.

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