Incentive stock options ("ISOs") are rights to purchase stock structured to comply with the requirements of §422 of the Code. If the requirements are satisfied, the holder, who must be an employee of the issuer, will not be subject to federal income tax either at the time of the grant of the option or at the time of its exercise; and gain realized on a sale of the underlying stock will be capital gain.
Incentive stock options must be issued pursuant to a "written plan" which includes the aggregate number of shares to be issued and the eligible employees (or class of employees). The option plan must be approved by the shareholders within twelve months before or after board approval, expire after ten years (five years in the case of a 10-percent stockholder), be granted pursuant to a plan less than ten years old, carry an exercise price equal to current "fair market value" (110 percent of such value if the optionee is a 10-percent stockholder), and be nontransferable. An incentive stock option may provide that the employee may exercise his option by paying with stock of the issuer and he may have a "right" to receive "property" in lieu of stock at option exercise. The exercise price in each contract will be fixed at "fair market value" of the stock at the time an option is granted. The grantee will have no more than ten years from the date of the grant in which to elect whether or not to exercise the option, which means, in effect, that the option will not ordinarily be exercised until the tenth year, since the prime virtue of an option is that it allows the investment decision-maker to postpone his decision until the last instant. Eligible grantees include only employees of the corporation and the options are not assignable. The rule that incentive stock options on no more than $100,000 worth of stock could be granted in any year was redefined by the Tax Reform Act of 1986 so that, effectively, the plan can grant options at the outset on $1 million worth of stock, but the amount of options which vest in any year during the ten-year period cannot exceed $100,000. The effect of this provision is to allow the same amount of options per individual as under the old rules, but to validate the use of the earliest possible (and presumably lowest possible) exercise price throughout. The oldest options need no longer be exercised first, a significant benefit in any scenario in which the price of the issuer's stock fluctuates both up and down and options are granted sequentially.
Usually, the plan also establishes a committee of the board (not including anyone eligible to participate in the plan) to "administer" the plan—that is, to grant the options—and sets up a system for tying options to performance. Dribbling out grants of options over a period of time can work to tie rewards to performance, but such a procedure means, in a rising-share-value scenario, that the grantee's exercise price will escalate. Hence, the better-drafted plans over-grant the number of options in the early stages (a procedure made easier by the Tax Reform Act of 1986, as earlier indicated) and then provide for "vesting"; that is, the power of the issuer to recapture granted options lapses in decreasing amounts as the employee's longevity increases. Once an employee terminates or is terminated, he must exercise his options (only those vested, of course) within a short period: usually a month (and not, by law, more than three months) after termination, meaning he loses the ability to postpone his investment decision. (On the other hand, to preserve ISO status, he must hold the option stock for one year before selling it.) The short fuse on post-termination exercise increases the possibility that a terminated employee's vested options will be allowed by him to lapse (and go back into the pool for someone else).