What Are Stock Options? And Do You Want Them?

On Jan. 1, 2004, X Corp. grants Rachel, an employee of the company, an ISO under which she can purchase 100 shares of X stock at $10 per share over a 10-year period. On July 10, 2004, when the fair market value of X stock is $20 per share, Rachel exercises the option to purchase all 100 shares by paying $1,000 for stock that has a fair market value at the time of $2,000. Rachel recognizes no income tax consequences upon the grant or exercise of the ISO.

Three years later on Nov. 30, 2007, Rachel sells the 100 shares of X stock for $25 per share. The difference between the $2,500 sale price and the $1,000 tax basis is long-term capital gain because Rachel held X stock for more than one year after the exercise of the ISO. But as noted in the next section, simply holding the stock for one year is no guarantee of capital gain treatment; ISOs cannot be transferred by the employee to any other individual or to a charity other than by a will, or pursuant to the laws of descent and distribution. Thus ISOs cannot be used to make lifetime charitable gifts. An ISO that passes at the death of the employee continues to be treated as an ISO in the hands of the beneficiary, including if the beneficiary is a charity. However, because a charitable beneficiary is a tax-exempt entity, the income tax advantages of an ISO could be lost. For this reason, donors may be well advised to use ISOs for non-charitable purposes and fund charitable gifts with other assets.

Transferral of stock
While ISOs cannot be transferred during the owner’s lifetime, the stock acquired through the exercise of the ISO is not subject to the same restrictions. Care should be taken to ensure that the gift of stock will not be treated as a disqualifying disposition. If the stock is donated to a charitable organization within one year of the exercise of the ISO, or within two years of the date the employee was awarded the ISO, the donor will realize ordinary income at the time of the donation equal to the difference between the fair market value of the stock on the date of transfer and the strike price. In addition, if the disqualifying distribution results from the contribution being made within one year of ISO exercise, the charitable income tax deduction will be limited to the donor’s tax basis in the contributed stock.