Incentive stock options are most commonly used to invest workers in their company's success. A stock option is a right that is granted that allows the owner of the option the ability to buy a quantity of a company's stock at some point in the future at the current price per share.
This motivates the worker to help improve the company towards a rise in stock value. Qualified and disqualified ISO's promote the same incentive principle, but with a couple of practical and important tax-related differences.
A "qualified" ISO allows you to escape personal taxation of any profit made in the exercising and subsequent sale of the ISO's. This comes in the form of two separate tax savings. At the point the option is exercised, you are exempt from paying tax on the gain between the option-grant price (when the option was issued), and the time-of-exercise-price of the stock(when the shares are purchased).
Secondly, at the time you sell the stock, the profit on the sale qualifies for taxation as a long-term capital gain, usually a lower rate than personal income.
An ISO must meet two holding criteria to qualify for tax breaks:
1) An ISO is disqualified if it is sold less than two years after the date the option was granted. This disqualification obligates you to pay tax on the spread between the exercise and market prices.
2) An ISO is also disqualified if it is sold less than one year after the date of exercising. Profit is then taxed as earnings rather than a capital gain.
A "disqualified" ISO may not have any tax savings, and may take a double hit on taxes. The spread between issue and exercise prices is taxed at your regular income rate in the year of exercising.
For example, an option for 1,000 shares at $1 per share will cost you $1,000 to exercise. If stock currently trades at $2 a share, you are taxed on the $1,000 spread as though it were income. The same is true if you sell your stock within a year of exercising the option to purchase the shares. Twelve months after the date of exercising it becomes taxed as a capital gain.
Favorable tax treatment comes at a cost of increased risk for qualified ISOs. Conditions for qualified sale of the stock can be met in a minimum of two years from the time of issue. Thus, a quick profit on a fast turnaround of options is tempered by the increased tax burden.
While there can be substantial tax savings on qualified stock options designed for long term holding, the risk of the stock price decreasing may or may not be favorable to the holder of the options.