 Hello and welcome to the session in which we will discuss incentive stock options or known as ISO. The first thing that we want to know is what are stock options. If you don't understand what stock options are, you will not be able to understand what incentive stock options are. Well, when you work for a company, you might be granted stock options. Simply put, granted means given to you by the company. Let's assume a company like Intel. And matter of fact, I used to work with Merrill Lynch, which is an investment, a brokerage firm that used to handle the employee stock options for companies like Intel, Tyco, PepsiCo and many other companies. So you work for an Intel and let's assume the stock price of Intel, the market price today is $25. So this is the market price. You start with Intel and they will give you, they will grant you. The term is they will grant you 1,000 options, 1,000 options to buy the stock at 40. Well, right now, this option is worth, worthless. Why? Because you would, you would buy the stock at 1.5. Why would you buy it at 40? But they will give you 10 years to buy the stock. So there's a period of time. There is like, for example, we're going to say 10 years. And also what they would do, they might have a vesting period. For example, you have to work for Intel one, two, three, whatever year. So you have a vest vesting period. So today is the grand date. Today is the grand date. And let's assume three years from now you vest just for the sake of illustration. After three years, let's assume the stock price of Intel is 55. Now your option is in the money. In the money means it's worth something. Well, it's worth something. It's worth, it's double. Like basically you can buy it for 25 and sell it immediately for 55. If you did, let's assume you decided to exercise the option. Exercise means buy the stock at 25 and you can immediately sell it at 50 if you choose, but we're going to talk about the tax consequences of that later. But the point is you can exercise the options. This is called the exercise, the exercise date, OK, whatever that date happens to be three years later. Then after you exercise it, you can either sell it today and we're going to see what the tax consequences are for ICOs or wait, then sell later. But this is basically what you need to be familiar with at least to start talking about stock options. We have a grand date, which is today. We have an exercise date when you actually buy the exercise, buy the stock using what's called the strike price. The strike price is 40 and there is the eventually you will sell the stock. So that much you have to know before we proceed any further. I have a public announcement about my company, Farhat Lectures dot com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation, as well as your accounting courses. 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And if it's not qualified, then guess what? It's non-qualified. If it's not qualified, it's non-qualified. If it's qualified, then it's a qualified. It's either ISO or employee stock purchase plan. Now, we need to discuss the qualification requirements. Well, first, the options must be granted to key employees under a plan approved by the shareholder. So the shareholders, the owners of the company will have to approve it. They have to vote on it. Also, it should be granted within 10 years, 10 years from the date to which the plan was adopted or approved. So after you approve it, you have 10 years to grant those options. You cannot wait more than 10 years or whichever comes first. So make sure you have 10 years to implement the approval. If it's longer than 10 years, you have to get that approval again. Those are requirements. The employees are required to exercise the option within the period of 10 years from the date on which the stock was granted. So once you grant them the stock, they have a 10 year period to exercise it. Employees are not allowed to own more than 10 percent of the combined voting power of the corporate stock as of the grand date. Simply put, they cannot be a majority, not majority, own more than 10 percent. When you own more than 10 percent, you're a substantial owner of the company. You cannot, you cannot be one of these people. OK, so it's key employees, but you cannot own more than 10 percent. Also, the exercise price should be at least equal to the fair value of the fair value of the stock at the grand date. If you remember the Intel stock, the market price, I said 25. So you cannot grant them the option to buy it at 20 because the option is already in the money. So the exercise price has to be at least 25. 25 means they're neutral. They have, you know, there is nothing. There is no value to the stock. But if you say you want, I give you the option to buy it at 40, it's out of the money and that's what they want you to do. ICOs has to be out of the money. They have to be out of the money. In addition, you remember, you have to be, you have to be familiar with those qualifications for the stock option to qualify as an ISO. And we're going to see why you want it to be qualified as an ISO. Once the stock is exercised, it must be held by the employee at least one year after the exercise date. It's worth going back and looking at a timeline. So this is the grand date. This is the exercise date. So after you exercise it, you have to hold it for one year. One year to be what? To be considered an ISO. After you hold it for one year, then you sell it afterward, simply put, after you hold it for one year, it will qualify. It's not, that's not the only condition. There's a second condition and two years from the grand date. So let's assume this is one year period from the grand date to the exercise. There is one year here. So you waited one year from the grand date to the exercise and you waited another year after the exercise. You met this period in total of two years. You have an ICO as far as you are meeting the holding period. Why is that important? That's why that's why we need to know because once you meet this holding period, then when you sell it, it is capital gains. Well, if you don't need this period, if you sell it here, it's ordinary income. Usually ordinary income is higher than capital gain. That's why you want to qualify as an ISO and incentive stock option. Also, the employee should remain and also the employee should remain employee of the corporation from the option grand date till three months before the exercise date. So you have to be an employee and this period is extended to one year if the options were granted to a permanent or disability or the total disability. Well, just FYI. Now let's talk about the taxation of an incentive stock options. How the employee as well as the employer is taxed because this is what we're concerned with. Well, the ISOs are not stock compensations. Therefore, the employee is not taxed when the stock is granted. This is in contrast to the non qualified. Remember under the non qualified, as soon as we grant them the stocks, there's a tax consequences for the receiver. The basis for the stock for the employee equal to the sum of the stock exercise price and any amount paid. So you need to know what your basis are. Well, your basis when you exercise at the stock price, stock price, which is the exercise price. And if you happen to pay any amount fee to buy to exercise that option. That's your basis when the stock is subsequently sold. The employee generally recognize a capital gain or a capital loss. Again, depending if you meet all the qualification that we talked about in the prior session, if the requirement listed above, which is on the previous slide are not met, as I told you, it's ordinary income. It's considered ordinary income. Now this is again in contrast to non qualified stock option. Be careful of the option lapse. Lapse mean going back to the Intel stock, the option price is 20. If the stock is always below 25 for 10 years, then the stock options that they gave you are worthless. The company is not doing well. You cannot recognize a loss. Why not? Because you did not recognize ordinary income where it was granted to you. So there is no loss because you did not recognize any income. So if the option happened to lapse. Also, each employee is not allowed to exercise more than 100,000 of these options. So you are limited. If you have more, guess what? It becomes non qualified. You're not meeting the requirements, non qualified. It's ordinary income. So this is don't worry. We'll work an example on the next slide and guess what? The taxation of the employer. Easy. They're not treated as compensation. If they're not as an expense compensation, they receive no tax deduction. There is no deduction for the employer. Simply put, that's what we are saying here. The best way is to illustrate this with an example. On March 15, genres receive an ISO. We're telling you it's an ISO. Now I could give you an example where I tell you, is this an ISO? Well, does it meet the requirements? Okay. Or what are the requirements for a stock option to meet in order for it to be treated as an ISO? I'll give you the options. But here I'm telling you it's an ISO. The number of shares to be purchased 200. The exercise price per share, we can buy it at $100. Fair market value of the stock on the grand date is exactly $100. They're making it easy, but if it was $99, then this is no longer an ISO. So at least equal to the fair market value. Usually when they grant you, they will have the exercise more than the current price. But again, I'm just illustrating the point. On April 3, year two, when the fair market value of the stock is $120, John decided to exercise the option and buy the $200 shares. Then after they exercised them, they wait until May 10th, year three until they sold them and they did good. They waited and the price became $180. So they had not exercised and sold, which is if they exercised and sold, remember, they will be taxed as ordinary income for the difference. And not only that, they waited a year later and they sold it for $180. And now all the gains is subject to capital gain, which is that's what they really want. So the first question, should John report any income on the grand date? And the answer is no. Given that it's an ISO and they met all the qualification, I already told you they met all the qualification. They don't have any recognized income on the grand date or the exercise date. We already know about the grand date, also the exercise date. Determine the adjusted basis of the stock held by John on April 3rd, year two, the adjusted basis is the stock exercise price, which is $100, can buy 200 shares. Their basis are 20,000. What amount, what is the amount and the type of income that John would report when he sells the stock? He sold the stock May 10th, year three, which is held it for a year. And from the exercise to the grand date, also there are two year period. We are in good shape. As of May 3rd, John has already met the requirement related to the holding period. Therefore he would recognize a capital gain of 16,000. How it's the difference between the selling price 200 shares times 180. He received $36,000 in total. The basis was the 20,000. And guess what? It's not only that it is capital gain. Is John employer allowed to receive any deduction for tax purposes? And the answer is no, these are not compensation. Therefore they cannot, they cannot treat it as a tax deduction, which is it's good for the employee, not good for the company. If it's an ISO, so you need to know this because in taxes, we like deductions, companies like deductions. And for an individual, but if you, if, if the individual wants to choose, if they can choose between ordinary income and capital gain, they would always try to treat it as capital gain, which is an, that's what the ISO will give you. What should you do now? Go to far hat lectures and work additional multiple choice through false additional exercises, anything that's going to help you, whether you are an accounting student CPA or EA candidate, study hard. Accounting is worth it. Invest in yourself. I'm always here to help you and stay safe.