Let’s consider Jill, who becomes an employee of XYZ Company in June 2018 and is given an incentive stock option for 1,000 shares at a grant/exercise/strike price of $5. Shares will vest at 25% per year:
- June 2018: Stock option granted
- June 2019: 250 shares vested
- June 2020: 250 shares vested
- June 2021: 250 shares vested
- June 2022: 250 shares vested
In June 2022, all 1,000 shares of XYZ Company’s stock have vested. Jill decides to exercise her option to buy all 1,000 shares at her grant price of $5 per share when the value of XYZ Company’s stock is $50 per share.
Jill writes her company a check for $5,000 (1,000 shares x $5 per share), and the company in returns gives Jill 1,000 shares of stock. Jill is now officially a stockholder.
With an incentive stock option, Jill would not have to pay taxes on the $45,000 IF she held on to the stock for at least a year after she exercised her options.
This is the most significant benefit of an incentive stock option: Jill will only pay long-term capital gain on the stock when she sells.
If Jill does not wait more than 1 year before selling her stock, she WILL pay ordinary income taxes on the $45,000 bargain element AND any gain.
Form 3921: Jill’s employer will complete Form 3921, “Exercise of an Incentive Stock Option”, and submit it to the IRS whenever Jill exercises her option to buy company stock.