What’s the Attraction of Incentive Stock Options?

As a securities lawyer, I like option plans.  Options awarded to employees, directors, consultants and advisors pursuant to a plan are exempt from registration under Rule 701 of the Securities Act of 1933, as amended. Each state has a corresponding exemption from its Blue Sky laws; in Washington that exemption is found in RCW 21.20.310(10). 

An option plan requires certain formalities. The plan must specify the total number of shares that may be issued and the persons who are eligible to receive the options. The plan must be approved by the shareholders within 12 months before or after plan adoption.

The options awarded under the plan can be either Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs).  ISOs may be granted only to employees; grants to non-employee directors or independent contractors are not permitted. The holder must exercise the option while employed or no later than three months after termination of employment. In contrast, NSOs may be awarded to any person covered by the plan, and there is no required limit on the exercise period, although plans often impose one.

Of course, NSOs are the same thing as warrants that are awarded without reference to a plan. Many start-ups that aren’t going to be awarding ISOs opt for warrants, but that leaves the securities law issues unresolved.  Is the award of the warrant a private placement under Section 4(a)(2) of the Securities Act?  Probably, in most cases.  However, for the same reasons that offerings to investors are made in reliance on Rule 506 of Regulation D, no one (and certainly no securities lawyer) can tell you exactly what a private placement is, which is why I prefer awarding NSOs under an option plan.

Given the restrictions on ISOs, what’s the attraction?  Well there were tax advantages for ISOs when they were first introduced in the tax code. If the employee holds ISOs, he does not have to pay ordinary income tax on the difference between the exercise price of the option and the fair market value of the shares issued (the so-called “spread”) at the time of exercise. Instead, if the shares are held for one year from the date of exercise and two years from the date of grant, then the profit made on sale of the shares is taxed as long-term capital gain. Long-term capital gains in the U.S. are taxed at 20%, while ordinary income may be taxed as high as 39.6%, depending on the employee’s tax bracket.  If the option is an NSO, the employee will owe tax on the spread at ordinary income tax rates when the option is exercised. But because the employee isn’t counting on capital gains tax treatment on an NSO, he doesn’t have to hold the stock for a year and risk that the price drops and his profits erode. 

In general, capital gains are not all that they are cracked up to be. From the combined perspective of the start-up corporation and the executive, salary and bonus compensation is more tax efficient than converting option compensation into capital gains.  That is because the corporation can deduct compensation expense from its taxes.  This is true of the spread on an NSO at the time of exercise. There are no tax deductions for the corporation associated with ISOs.

In 1982, the U.S. introduced the Alternative Minimum Tax (AMT). Spreads on ISOs, but not NSOs, are subject to this tax.  The AMT has a high exemption level.  For single people, it’s $53,900 in 2016 and starts phasing out at $119,700.  That means the AMT is a tax on relatively wealthy people, but almost all executives who are awarded options presumably fall into that category.  The AMT rate is steep, 26% to 28% depending on income.  That’s often more than enough to offset any tax advantages that ISOs were intended to achieve.  After all, ordinary tax rates are at most 19.6% higher than capital gains rates.

Further, for public companies where there is a market for the stock and the stock price may be relatively stable, vested options that are in-the-money can be readily converted to profits, even if the employee or former employee holds ISOs.  But for employees of a start-up corporation, the requirement that options be exercised within three months of leaving is toxic.  There is little chance that a start-up not already in play is going to have a liquidity event in three months, so the option holder may have to exercise and take a huge gamble that the corporation will succeed years later and the stock he now holds (and for which he had to pay the cash exercise price and a whopping AMT amount) will someday be worth more than he paid.

What’s the attraction of Incentive Stock Options?  Beats me.

John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington.   This posting does not constitute legal advice.