Deep Dive: Unlocking the Potential of Incentive Stock Options (ISOs)
Incentive stock options can feel overwhelming for even the most seasoned startup employee and we get it—there’s a lot to cover and understand. To help break down all the ins and outs of ISOs for those joining the start-up life, scroll through our deep dive to learn more and get your questions answered. If you’re looking for something a little more skimmable, check out our ISOs 101 article!
Let’s get into it!
What is an Incentive Stock Option?
Incentive stock options (ISOs) are a type of stock option that is granted to employees as a form of compensation. Similar to an employee stock purchase plan, ISOs give employees the right to purchase company stock at a predetermined price called the exercise price or strike price.
EXERCISE PRICE: The exercise price, also known as the "strike price," refers to the predetermined price at which the option holder can purchase the underlying stock when they choose to exercise the option. This price is determined at the time of the option grant.
Exercising your ISOs
Exercising a stock option means purchasing the company stock at the price set by the option (grant price), regardless of the stock's price at the time you exercise the option.
Once you exercise your incentive stock options, you'll own actual company stock shares. From that point forward, the timing of selling your shares is at your discretion. You can opt to sell them right away or continue to hold them indefinitely.
When to Exercise
If you hold for more than a year after exercising an incentive stock option and more than two years after the option was granted, the gain from your exercise price to the price you sell your shares for will be taxed at the long-term capital gains rate, which is generally lower than the ordinary income tax rate.
However, if you sell the shares before meeting those holding period requirements, you'll be subject to the ordinary income tax rate on the difference between the fair market value of the stock at the time of exercise and the exercise price.
In general, you may want to exercise your ISOs when the stock price is low, especially if you believe the company's stock price will increase in the future. This can help you maximize the potential gain on the shares.
However, you should also consider the tax implications of exercising your options and any potential restrictions on selling the shares. Working with a financial planner or tax professional who can help you make the right decision for your specific situation is important.
Exercising Depends On:
Your financial goals,
The state of the company,
The price of your options, and
Your potential tax cost
Advantages of ISOs
ISOs offer several tax advantages compared to other types of stock options (However, it's important to note that there may be an alternative minimum tax (AMT) liability when you exercise your incentive stock options!)
1. Potentially no tax liability at exercise
The first tax advantage of an incentive stock option is that there is are two paths to having zero tax liability at exercise. The first is to exercise when the company stock FMV matches your strike price.
Similar to NSOs, this can be achieved with an early exercise or, if the company is private, doing so before any 409(a) valuation change. Unlike NSOs, the other path to achieving this is to review your regular tax vs. your alternative minimum tax to understand the difference between the two.
For most taxpayers, regular income tax will be higher than AMT. Therefore, there is a path to exercise a portion of your ISOs by only exercising the amount that brings your AMT up to your regular tax. We call this the “AMT Free Zone”.
2. Lower tax rates
If you hold onto the shares for at least one year after exercising your options granted through incentive stock options and two years after the grant date, any gains on the sale of the shares will not be taxed as ordinary income but at the lower long-term capital gains tax rates. Unlike NSOs, this applies to the full balance of your gains which we can break into two components: the gain from your strike price to your FMV at exercise and the gain from your FMV at exercise to the price you sell your shares. ISOs are unique in that if you met the qualifying holding period, both components are taxed at long term capital gains tax rates.
This can result in significant tax savings compared to other types of stock options, which may be subject to ordinary income tax rates on the gains from the sale of the shares.
3. Lower appreciation tax rate
Similar to NSOs, if you exercise your ISOs and hold onto the shares for at least one year after exercising them, any potential appreciation in the value of the shares above the FMV at exercise will be taxed as a long-term capital gain.
Disadvantages of ISOs
While there are upsides to ISOs, it’s also important to note that when you exercise your incentive stock options, there can be some downsides, including possible subjection to an alternative minimum tax (AMT) liability.
1. Alternative minimum tax (AMT)
The difference between the fair market value of the shares at the time of exercise and the exercise price is considered a tax preference item for alternative minimum tax purposes. This means that the amount of the gain will be added to your regular taxable income for AMT purposes.
The AMT calculation is complex and depends on a variety of factors, including your income level, deductions, and credits. If the AMT calculation results in a higher tax liability than your regular tax liability, you will be required to pay the AMT. However, any AMT liability you incur due to exercising your ISOs will be converted to AMT tax credits that can be recovered in future tax years.
We highly recommend that you discuss your options with a financial planner or tax professional with specific experience working with ISOs and the AMT to help you navigate the complex tax rules and make informed decisions about your ISOs.
2. Restrictions on ISOs
There are a few restrictions on ISOs that employees need to be aware of.
ISOs are only available to employees of the company and not to independent contractors or consultants.
There are limits on the number of ISOs that can be granted to an individual in a single year. Currently, the limit is $100,000 worth of options per year.
There are specific rules regarding the timing of exercise and sale of ISOs. If you sell the shares before meeting the holding period requirements mentioned earlier, it can trigger what's called a disqualifying disposition. In this case, you'll be subject to ordinary income tax on the difference between the stock's fair market value at the time of the exercise date and the exercise price, as well as any gains realized on the sale of the stock.
3. Disqualifying dispositions
A disqualifying disposition occurs when you sell your ISO shares before meeting the holding period requirements. There are a few situations in which a disqualifying disposition can occur:
You sell the shares before the end of the one-year period after exercising the ISOs.
You sell the shares before the end of the two-year period after the option was granted.
You sell the shares after the two-year period but before the one-year period after exercising the ISOs.
In any of these cases, the gains you realize on the sale of the shares will be subject to ordinary income tax rates rather than the lower long-term capital gains tax rates. This can significantly increase the amount of taxes you owe on the sale of the shares.
It's important to carefully consider the potential tax implications of exercising and selling your ISOs and the potential benefits of holding onto the shares for a longer period to meet the holding period requirements.
If you’re looking for any additional help, one of our advisors would love to chat with you!
Alternative Minimum Tax (AMT) Explained
Before diving into more detailed information, let’s look at what exactly is the alternative minimum tax.
The Alternative Minimum Tax (AMT) is a separate tax system in the US designed to ensure that taxpayers with certain types of income and deductions pay at least a minimum amount of federal income tax. This system can affect taxpayers who exercise Incentive Stock Options (ISOs).
Think of the alternative minimum tax as a parallel tax system to your ordinary income taxes; these two calculations occur in every tax return, with the taxpayer paying the higher of the two calculations.
AMT Free Zone
When you exercise ISOs, the bargain element is not added to your ordinary income taxes. However, it does get added to your alternative minimum tax calculations.
Since the ordinary income tax and AMT calculations have different rates, the "AMT free zone" strategy is intended to create a scenario where you can exercise a certain number of ISOs while ensuring that your ordinary income tax remains the higher obligation.
In other words, it's a strategy to ensure that you understand the difference between your ordinary income tax and your alternative minimum tax so that you can calculate how many options you can exercise without letting your AMT cost more than your ordinary income tax.
In this way, the only cost to your exercise would be the exercise price but no tax liability from AMT.
BARGAIN ELEMENT: The bargain element, in the context of stock options, refers to the difference between the market value of the stock at the time of exercise and the stock option's exercise (or strike) price. In other words, it's the "discount" or "bargain" the employee receives when they exercise their stock options to purchase shares below their current market value.
Example: AMT Free Zone
Let's say that John is a Vice President at XYZ Tech Co and was granted 1,000 ISOs at an exercise price of $10 per share. The fair market value (FMV) of the stock at the time of the grant was also $10 per share (so no discount).
John decides to exercise all of his ISOs when the FMV of the stock is $20 per share.
In this case, he has decided to hold onto the shares to achieve long-term capital gains when he sells. Since these are ISOs, this bargain element of $10,000 ($20 FMV - $10 strike price x 1,000 options) is added to his alternative minimum tax calculation. This $10,000 bargain element is not added to his ordinary income.
Since John is a VP, he likely has a high salary, so let's say his ordinary income tax liability is $150,000. In parallel, let's say his alternative minimum tax liability is $120,000 prior to this exercise.
If we add in the $10,000 bargain element impact into his AMT, his ordinary income tax liability would still be higher. Therefore, John did not create an AMT liability by exercising his ISOs and stayed under the "AMT free zone."
The alternative minimum tax is affected by many different factors and can be quite complex, so it's always best to consult a tax professional to understand your specific "AMT free zone" calculation.
Optimizing ISO Equity
It's important to understand the potential risks and rewards of investing in your company's stock. While ISOs can provide a valuable source of compensation, they also come with a higher risk level than other types of investments.
Risk vs. Reward
If the company's stock price were to decline, your ISOs' value could also decrease. Unlike Restricted Stock Units, the value of your options can drop to zero before the company's stock drops to zero.
Make sure you also understand the potential upside of holding onto the shares for a longer period of time, as well as the potential risks of selling the shares too soon or holding onto them for too long.
Remember, you're granted the right to buy the company shares at a given price (strike price). If the company stock trades under that price, then your stock options are worthless even if the company's stock price is still well above zero.
Vesting Schedule
Most companies have a vesting schedule for their ISOs. Unless you’re able to “early exercise”, this means you won't be able to exercise your employee stock options until you've worked for the company for a certain period.
Double-check that you understand your ISOs' vesting schedule and plan accordingly.
Tax Implications
While ISOs can provide a tax advantage compared to other types of stock options, there are still tax considerations to keep in mind. Make sure you work with a financial planner or tax professional who can help you navigate the complex tax rules surrounding ISOs.
Additional Considerations for ISOs
Ensure you understand the company's financial situation and prospects for growth. ISOs can also be a valuable source of equity compensation, but they're only valuable if the company's stock price increases over time. It is essential that you understand the company's financials and prospects for growth before deciding to exercise your ISOs.
We also highly recommend diversifying your investment portfolio. It's important to have a diversified portfolio of investments that includes a mix of stocks, bonds, and other assets. This can help you minimize risk and maximize potential returns over the long term.
The rules surrounding ISOs can be complex, and it's important to work with someone who has experience navigating the complex tax and financial rules surrounding ISOs. If you have any questions or concerns, let’s connect!
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Incentive stock options can be a valuable form of compensation for tech professionals, but they also come with potential tax implications and risks.
By understanding the details of your ISOs and other equity compensation, you can make informed decisions about managing your investments and minimizing risk. Working with a financial advisor or tax professional is critical to ensure you're maximizing your ISOs and minimizing your tax liability.
If you’d like additional help understanding your options and planning for the future, we’d love to help.
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