Incentive Stock Options 101
Tech professionals are often offered incentive stock options (ISOs) as part of their compensation packages. ISOs can be a great way to align your interests with the company's, but they also come with potential tax implications that you must be aware of.
We’ll cover the top 10 things you need to know about ISOs, including how they work, their tax implications, and more.
1. WHAT IS AN INCENTIVE STOCK OPTION?
Incentive stock options are a form of equity compensation that gives you the right to purchase company stock at a predetermined price, known as the strike price. They are typically granted to key employees to incentivize them to work hard and help the company succeed.
ISOs usually come with a vesting schedule, meaning you'll need to stay with the company for a certain amount of time before you can exercise your options and purchase the stock. For example, you might be granted ISOs that vest over four years, with 25% of the options vesting yearly.
Fun Fact
Incentive stock options were initially created as part of the Tax Reform Act of 1986 in the United States. The act was designed to simplify the tax code and reduce tax loopholes, but it inadvertently created a tax break for certain types of stock options, including ISOs.
As a result, ISOs have become a popular form of compensation for tech companies and other industries.
2. HOW DO INCENTIVE STOCK OPTIONS WORK?
You must pay the strike price to purchase the stock when you exercise your ISOs. For example, if the strike price is $10 per share and you're granted 1,000 options, you'll need to pay an exercise price of $10,000 to purchase the stock.
ISOs typically have an expiration date, which is the date by which you must exercise your options or forfeit them. For example, your ISOs might expire ten years after they are granted.
STRIKE PRICE: is the predetermined price at which the option holder can purchase the underlying stock when they exercise the option.
STOCK PRICE AT TIME OF EXERCISE: the value used to determine your potential tax consequence.
BARGAIN ELEMENT: the difference between the stock price at the time of exercise and the strike price you pay to convert the option into shares.
EXERCISING OPTIONS: the process of converting your stock option into shares that you own.
3. HOW ARE ISOs TAXED?
ISOs have potential tax advantages compared to other types of equity compensation. Let’s begin by defining a few more terms:
SHORT-TERM CAPITAL GAIN TAX: tax cost that is imposed on profits from the sale of an asset held for one year or less, typically at the same rate as the individual's ordinary income tax.
LONG-TERM CAPITAL GAIN TAX: tax cost that is levied on the profit from the sale of an asset held for more than one year, usually at a lower rate than short-term capital gains.
ALTERNATIVE MINIMUM TAX: a parallel tax system designed to ensure that individuals and corporations who benefit from certain exclusions, deductions, or credits pay at least a minimum amount of tax. ISOs add to your AMT calculation, potentially creating a tax liability.
HOLDING PERIOD: the duration of time an investment is owned by an investor, from the purchase date to the sale date, which determines the tax treatment of any capital gains or losses. In this case, the period of time you held the shares after exercising.
QUALIFYING DISPOSITION: a stock sale post-exercise that meets IRS requirements for favorable tax treatment. In the case of ISOs, that is when the stock is sold two years after the option was granted and at least one year after the option was exercised.
Now that we have those terms defined, let’s take a look at a disqualifying disposition vs. a qualifying disposition:
4. WHAT IS THE ALTERNATIVE MINIMUM TAX?
One potential downside of ISOs is the alternative minimum tax (AMT). The AMT is a separate tax system designed to ensure that high-income individuals pay a minimum amount of tax.
When you exercise your ISOs, the difference between the stock's fair market value and the strike price is considered a "bargain element" and included in your AMT income. This means you could be subject to AMT even if you don't owe any regular income tax.
For example, if you exercise your ISOs when the stock's fair market value is $20 per share, and the strike price is $10, you'll have a bargain element of $10 per share. If you exercise 1,000 options at market price, your bargain element will be $10,000.
5. WHAT IS THE AMT CREDIT?
If you end up paying AMT on your ISOs this calendar year, you may be eligible for an AMT credit in future years. The AMT credit is designed to reduce the regular income tax you owe in coming years to offset the AMT you paid in a prior year.
For example, if you paid $5,000 in AMT in 2021, you may be eligible for a $5,000 AMT credit in 2022. This credit can be applied to your regular income tax liability in 2022, reducing the amount of tax you owe.
6. WHAT DOES “EXCERCISING STRATEGY” MEAN?
One common strategy for dealing with incentive stock options for privately traded stocks is to exercise and hold. Doing so can potentially achieve long-term capital gains tax treatment once you've met the holding periods. This is more common with private company stock because the stock price only changes during a funding round which is generally every 12-18 months for most unicorn-level companies. These infrequent pricing changes provide more stability in the strategy.
On the other hand, for publicly traded tech companies, a common alternative strategy is to exercise and sell. Under this strategy, you would exercise your ISOs and immediately sell the shares to lock in a profit.
The risk in exercising and holding is that there is no certainty in knowing that you will eventually sell your shares at a profit as the stock price could decline. Given market conditions for tech companies since the start of 2022, the volatility of pricing has given many concerns for trying to hold on for long-term capital gains tax treatment while risking a lower price stock when you sell.
7. WHAT ARE SOME OTHER FORMS OF EQUITY COMPENSATION?
ISOs are just one form of equity compensation that tech professionals may receive. Other forms of compensation income may include restricted stock units (RSUs) and non-qualified stock options (NSOs).
RSUs: similar to ISOs in that they give you the right to receive company stock at a future date but don't require you to pay a strike price. Instead, the value of the RSUs is based on the stock's fair market value at the time they vest.
NSOs: similar to ISOs in that they give you the right to purchase company stock at a predetermined price but don't have the same tax advantages. With NSOs, you'll owe ordinary income tax on the difference between the stock's fair market value and the strike price when you exercise your options.
8. WHAT IS THE RISK/REWARD OF ISOS?
Like any form of equity compensation, ISOs come with risks and rewards. The potential rewards include the ability to profit from the growth of the company and the potential tax advantages of ISOs.
However, there are also risks to consider. If the value of the stock declines after you exercise your options, you may end up paying more for the stock than it's worth. Additionally, there's always the risk that the company will perform better than expected, and the stock will stay the same in value.
9. WHY IS DIVERSIFICATION OF MY INVESTMENTS IMPORTANT?
It's important to remember that equity compensation is just one part of your overall investment portfolio. To minimize risk, it's important to diversify your investments across multiple asset classes, including stocks, bonds, and other investments.
This can help protect you from having too much of your wealth tied up in a single company's stock. If the company performs poorly or experiences financial difficulties, you'll still have other investments to fall back on.
10. WHAT ARE MY OPTIONS?
Finally, it's essential to understand the details of your ISOs and any other equity compensation you receive. This includes understanding the vesting schedule, the strike price, and the expiration date of your options. Some companies even allow you to exercise early through an 83(b) election so that you can start your clock for long-term capital gains tax treatment sooner.
It would be best if you also understood the tax implications of your ISOs, including the potential for AMT and the importance of holding onto your shares long enough to qualify for long-term capital gains tax treatment.
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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.
To learn even more about ISOs, check out our deep dive!
If you’re wanting additional help in understanding your options and planning for the future, we’d love to help.
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