Everyone wants “incentive stock options” (as such term is defined in the Internal Revenue Code) as opposed to non-qualified options, because of the potential to capture capital gains tax treatment after the exercise of the incentive stock options and the eventual sale of the underlying stock. The option holder hopes to pay capital gains tax (as opposed to income tax) on the difference between the exercise price of the option and the price at which the underlying stock is eventually sold. So, if you have options to purchase 100,000 shares the Mighty Software Corporation with an exercise price of $.20 per share when Mighty is sold to Microsoft for $2.00 per share, your hope is to realize $180,000 of profit. If you are taxed at the current long term capital gains tax rate of 15% you would pay $27,000 in tax and keep $153,000. Compare this result to paying tax at the highest marginal rate of 35%. $180,000 multiplied by .35 is $63,000. In this scenario, you keep $117,000 (or $36,000 less than if you had paid tax at the capital gains rate). 

The dirty little secret of incentive stock options is that the holder must comply with a variety of requirements under the Internal Revenue Code to actually get capital gains treatment. Among these requirements, is a holding period requirement the effect of which is to prevent the option holder from getting capital gains treatment in almost all cases. The holding period requirement is that one must hold the stock obtained upon exercise an incentive stock option for a minimum of one year in order to get capital gains treatment. In fact, you have to hold the option and the stock for a combination of two years, but at least one year has to be after exercise.

What is wrong with this? Nobody exercises stock options until there is a liquidity event or they are ready to sell the underlying stock. So, when Microsoft closes on the acquisition of Mighty, you will exercise your option and get cash, and you will be taxed at ordinary income rates. Ah you say, what if Mighty goes public? Well, if you exercise and hold for one year, you can get capital gains treatment, but you will be taking a risk that the market price of Mighty stock will decline during that period. Furthermore, most people cash in their options when they have a need for a chunk of cash, such as for a down payment on a new house. They do not exercise and hold.

One thing to consider that can mitigate this problem is to ask for restricted stock or to exercise your options (as soon as they have vested) and start the holding period. In the case of option exercises, you will have to pay the exercise price of $.20 per share (in our example). This means you would be out of pocket $20,000 and you would be taking the risk that the company will never have a liquidity event. In addition, the spread at the time of exercise (the difference between the exercise price and the value of the stock received) is a preference item for purposes of the Alternative Minimum Tax, which means that you end up paying AMT tax for the year of exercise.  In the alternative, you might obtain a grant of restricted stock, file an 83(b) election, take the value of the stock into income in the current year, and start your holding period. In our example, if $.20 is the fair market value of a share, you would have income of $20,000 on which you would pay income tax ($7,000 in our example), and absent a liquidity event, you might never recover this amount. Now, these numbers seem small, but if you are looking at stock with a valuation of $1.00 or some other high number, then the cost of exercising options or paying tax on a grant of restricted stock could be prohibitive. Your individual circumstances will have a significant effect on what will work best for you.

We structure our option plans to accommodate incentive stock options, non-qualified options and restricted stock. While everyone may want an incentive stock option, you should recognize that it is very unlikely that you will get the favorable captial gain tax treatement and think about any  different choices that you might have.