A common way to pay employees and encourage retention, is with an Incentive Stock Option. When a company provides an ISO, the common stock is offered to an employee at a particular price and time. The stock option allows the employee to decide when to purchase the stock and when to sell. An ISO must be exercisable within 10 years from the date it is offered and the employee’s price must not be less than the fair market value on the day it’s issued. The ISO offers an excellent tax opportunity for an employee in a high tax bracket. If it is carried out properly, the proceeds from the stock’s sale will be taxed as long-term capital gain. The stock is first valued on the date it is offered to the employee, or the grant date. On the grant date, the exercise price is determined; this is the employee’s set price for the stock. Once the employee decides to exercise his right to purchase stock, the employee will have an adjusted basis for future taxation. After two years from the grant date, and one year from the exercise date, the employee may sell the stock and receive long-term capital gain treatment. If the employee does not meet the holding requirements, a disqualifying disposition is used to determine the taxation. When the stock is sold at a loss, the employee will recognize the proceeds as ordinary income. A disqualifying disposition sold at a gain is taxed as a ordinary income and short-term capital gain. The ordinary income is the difference between the exercise price and the fair market value of the stock on the exercise date. Any gain over the ordinary income is taxed as short-term capital gain. The ordinary income is included on the W-2; however, payroll and federal income tax withholding do not apply. A cashless exercise option is available to employee’s that do not have the funds to purchase the ISO. When the employee decides to exercise his ISO, a third party lender will loan the money to purchase the stock at the exercise price. A cashless exercise requires the stock to be sold immediately. The lender is repaid and the employee recognizes ordinary income equal to the difference between the proceeds and the repayment.