I Seen a Girl on a One-Way Corridor, Stealing Down a Wrong-Way Street – Tax Opportunities with ISOs in M&A – Benefits Law Group Blog

by John Ludlum

Incentive Stock Options (“ISOs”) have a somewhat legendary status as equity incentives for technology and other early-stage companies. It is true that ISOs are one of two types of equity awards that can achieve capital gains treatment on the entire appreciation value of the awards—profits and interests are the other type. It is possible that an ISO share may be taxed at the long-term capital gains rate for the entire difference between the exercise price and the disposition price.

To achieve this advantaged tax treatment, an option must meet the requirements of Code § 421-424 and the associated regulations, which include, but are not limited to:

Required terms for the plan issuing the ISOs (shareholder approval among other terms)
Eligibility requirements (must be an employee at the time of grant, and loses ISO status three months after ceasing to be an employee)
Limitations on the number of ISOs a recipient can receive (no more than $100,000 can first become exercisable in a calendar year measured by the exercise price)
Other additional requirements

But the ISO requirement that is most often a barrier to the preferred tax treatment is the minimum holding periods, which require the ISOs to be held: (i) two years from the date of grant, and (ii) one year from the date of exercise.

In our experience, many optionees don’t have the advance notice and funds available to pay the exercise price more than a year from the date of an exit through a change of control, so they don’t meet the holding period requirements for preferred tax treatment. Instead—when they dispose of their shares—it is treated as a disqualifying disposition which results in what is basically a nonstatutory option (“NSO”) treatment (generally, income on the lesser of the spread at exercise and the spread at disposition, and where the price has gone up, capital treatment for the difference between the fair market value at exercise and the disposition price). While this is common, given the potential for the really advantageous tax treatment, we often advise clients that ISOs can be used in case they work out, and the worst that happens is effectively NSO treatment. There also can be business considerations. I have had clients prefer NSOs because the company generally will not get a deduction if an ISO results in a qualifying disposition of shares and the preferred tax treatment.

In mergers and acquisitions, there can be some advantages to ISOs that may get overlooked. While it is not common these days, it is permitted to “assume” outstanding target options and convert those to options for acquirer stock by making adjustments permitted under the Code to the exercise price and the number of shares, but otherwise continuing the option. This can allow the ISO to continue post-closing and the optionee to satisfy the holding period requirements under the Code. This usually only happens in situations where the target company and its service providers have significant leverage.

There is one other fine point to keep in mind. The exercise of an ISO results in no ordinary income tax event—it is an adjustment for the Alternative Minimum Tax or AMT—and there is no withholding for the company on the exercise of an ISO (when an NSO is exercised, the spread at exercise is ordinary income, and for employees, wages subject to withholding). So, if an ISO is exercised while an ISO, there is no income tax withholding, and no employment tax withholding either. Many times, employment taxes are not too much of a factor because there are annual caps on income subject to employment taxes, but one element of the employment taxes—the Medicare tax at 1.45% for each of the employer and employee—is not subject to annual income caps. So, exercising while an ISO can save the optionee and the company taxes, and even a 2.9% tax rate can add up if there is a large spread at exercise. In these cases, it can make sense to complete the exercise of an ISO even shortly before the shares are cashed out in a transaction.