The Simplified Guide to Incentive Stock Options

Key Points

• ISOs, or incentive stock options, are a type of employee stock option that can be a valuable form of compensation for both business owners and their employees.
• ISOs give employees the right to buy company stock at a discounted price, known as the exercise price, after a vesting period.
• One of the top reasons to use ISOs is that they can help companies attract and retain top talent by providing employees with a stake in the company’s success.
• ISOs can also help companies conserve cash by providing employees with stock instead of cash bonuses or other forms of compensation.
• Another advantage of ISOs is that they can provide tax benefits for both employees and employers, as employees may be able to defer taxes on the value of the stock until they sell it, and companies may be able to deduct the cost of the options as a business expense.

Introduction

ISOs (Incentive Stock Options) are one of the many types of stock options and equity compensation available for employers to use to compensate and retain their employees. Internal revenue code makes these preferred by most people over other types of equity compensation because of the potential for preferential tax treatment when used thoughtfully.

The hard part is, they have a rigid vesting schedule, including multiple points in time when you may be charged unique types of taxes and lots of obstacles that make them confusing. In this article, we’ll be explaining what ISOs are, their benefits, how they work, how they’re taxed, and how to think about your strategy as you use yours. If you have questions about your stock options, feel free to schedule a free appointment by clicking here.

What are ISOs?

ISOs, or Incentive Stock Options, are a type of employee stock option that offers tax advantages to both the business owner and the employee. ISOs are typically granted to key employees as a way to attract and retain talent.

There are a few key things to know about ISOs:

1. ISOs are only available to employees – they cannot be extended to contractors or consultants.

2. The exercise price of an ISO must be at least equal to the fair market value of the underlying stock on the date of grant.

3. ISOs have a holding period requirement – employees must hold onto their shares for at least one year from the date of exercise before selling them in order to receive favorable tax treatment.

4. There is no limit on the number of ISOs that can be granted in a given year, but there is a limit on the total amount that can be exercised in a single year (the “annual limit”). The annual limit for 2020 is $110,000.

5. gains from selling ISO shares are taxed as capital gains, which are typically lower than ordinary income tax rates.

The benefits of ISOs for employees

There are many benefits of ISOs for employees. One benefit is that they can receive a tax-free bonus if their company’s stock price goes up. Also, if the company does well and is sold or goes public, employees with ISOs can make a lot of money. Finally, if an employee leaves the company, they can often cash out their ISOs at a profit.

How Do Incentive Stock Options Work?

The first step with all ISOs is your company granting them to you. Normally, at the time of the grant, you’ll be informed of your grant price, how long until the ISO vests, the ISO’s expiration date, and the number of shares of stock you can purchase at the fixed price built into the ISO.

Your grant date is an incredibly important date to remember because this plays a role in whether you make a qualifying disposition or a disqualifying disposition, which we’ll get more into later how this plays a role in your tax bill.

As mentioned above, the benefit of owning an ISO is having the option to purchase your company stock at a predetermined price (AKA the ISO’s strike price) or in the open market at the market price (whichever is lower). This can be incredibly beneficial because what if your company’s stock is selling for far more than your fixed purchase price?

When you decide to purchase your company’s stock via the exercise of the option, you’ll have to decide on your exercise method which can include either an:

• a cashless transaction
• an ISO exercise

The last step in the process is to sell the stock you purchased with your ISOs at a higher price than you bought it for.

What price can you sell the stock you acquired with your ISOs for?

Either at:

• The market price, which can change every day, or,
• at the Most Recent Tender Offer your company provides.

How do taxes work for Incentive Stock Options?

Since your ISOs could potentially offer you an incredible discount on the stock you hope to buy, the IRS definitely keeps an eye on these. The question is, how much tax should you expect? There’s no perfect answer to this because the tax bill depends on numerous different factors that we’ll be explaining to you.

Note: as always, this isn’t tax advice. Be sure to talk to your tax advisor or a licensed financial advisor before taking any action.

There are two different times you may be required to pay taxes on your ISOs:

• When you exercise your ISOs
• When you subsequently sell the stock

Here’s what you need to know about each step:

When you exercise your ISOs, you’ll have to first pay taxes on something called the bargain element. The bargain element is the difference between your predetermined purchase price (aka, Strike Price) and the market price (or the most recent 409a valuation if your company isn’t public).

This is when it gets tricky. The tax consequences don’t apply to everyone, however. You’ll be required to pay something called “Alternative Minimum Tax” (AMT) when you file your tax return if your AMT obligation exceeds your tax obligation that’s generated by filing your 1040, normally. Alternative minimum tax is something typically set aside for the ultra-wealthy but since ISOs can be extraordinarily valuable, the IRS pays special attention to the tax returns of people who own them. This is part of the reason why AMT is potentially a problem for you.

Here’s how to calculate if you owe taxes when you exercise your ISOs.

How do you calculate your AMT obligation before the exercise of an ISO using Turbotax?

First, complete your 1040 but don’t include your ISO exercise. You can use Turbo Tax Premier or other tax filing software for free to calculate your tax obligation. Be sure you don’t file your return (yet), however.

Now take the following steps:

1. Note your total tax amount $ for both state and federal. This is your baseline tax.
2. Now enter an ISO exercise by going back to the question where you initially said No. This time say “Yes”.
3. Enter the number of shares, exercise price, and Fair Market Value at the time of the exercise. Normally, you would be entering this information from IRS Form 3921 which your company would have sent you in January of the year following your exercise.
4. Once you submit your ISO exercise event, your total taxes for both Federal and State should immediately update.
5. The difference, if any, between this updated tax figure and your baseline taxes noted earlier (1) is the AMT tax associated with your ISO exercise.
6. Let your Financial Planner at Progress Wealth Management know this figure if you want PWM to include this amount in your cash advance.
7. To calculate how many ISOs you can exercise each year without triggering AMT tax, enter a smaller number of shares in (3) and gradually increase it until your tax due actually increases over the baseline calculation.

How do you calculate your tax obligation when you subsequently sell the stock?

At one point, you’ll want to sell the stock you acquired through your ISOs, and hopefully, you’ll sell it for more than you paid for it initially. Unfortunately, the IRS will want their piece, too but at what tax rate will they charge you? Unfortunately, it depends on a few factors.

Here are the two questions you should be asking yourself.

1. How long did you wait to exercise your ISOs following your grant date?
2. How long did you wait to make a sale of the stock following your exercise of your ISOs?

These two questions are focused on the holding period requirements because depending on your answer, it changes how it’s taxed.

If your exercise date of your ISOs is no earlier than 12 months following the grant and sold the stock no earlier than 2 years after the grant and 1 year after your exercise, you’ll be able to make a qualifying disposition which means the tax rate charged on your bargain element (the difference between your predetermined purchase price and sale price) will be at preferential tax rates… which are long-term capital gain rates (between 0% – 20%).

If your exercise date is within 12 months after your grant date or if you sell within 2 years from your ISO grant or 1 year from exercise, you’ll have made a disqualifying disposition meaning that instead of long-term capital gain rates, you’ll pay taxes at your ordinary income rate (potentially as high as 49% depending on where you live).

What problems can come up from Incentive Stock Options?

Problem 1: AMT may be unaffordable for you.

If you’re an option holder that owns some Incentive Stock Options on a privately traded company (aka, isn’t traded on the New York Stock Exchange or OTC), you may exercise your ISOs and not be able to sell them until the next tender offer… which could be literally years away. This means you may owe a potentially massive amount of AMT and not have sufficient liquidity to afford it.

In other words, think about it this way. Lets say hypothetically you own 50,000 ISOs with a strike price of 10 cents meaning that you can buy 50,000 shares of your company’s stock for $5,000. Your company’s most recent 409a valuation was $100.00 per share so your shares are worth (50,000 shares x $100 per share = $5,000,000). a million dollars. Your bargain element is 5 million dollars – 5 thousand dollars = $4,995,000. Let’s also say you earn $350,000 a year as your annual salary.

If this is your scenario, you likely owe roughly $1,494,621 in AMT.

Here’s the math assuming you file taxes single:

Income 350,000

+ Adjustment 4,995,000

AMT Income 5,345,000

— AMT Exemption 0

AMT Base 5,345,000

Tentative Minimum Tax 1,494,621

(26% or 28% of AMT base)

Ordinary Income Tax 180,090

Payable Tax: 1,494,621

(Greater of tentative minimum tax or ordinary income tax)

Max ISOs to avoid AMT: 3,325

Problem 2: The value of the stock could make up the bulk of your life savings and it could perform poorly.

Many tech professionals at startups receive ISOs early on and exercise them at their first opportunity because they don’t want to pay AMT and have a boatload of stock they can’t sell. They get really confident that their company is going to do incredibly well, so they stop saving and start living large. To their surprise, their company may not meet their expectations. In fact, many startups fail and the years that they could have been saving have now been thrown away.

Although you may be confident in your company (we all are), remember that things may go awry and your confidence could be unfounded. This is why it’s so important to be conservative with your estimates, frugal with your spending, work hard and ask for raises at least once a year.

Conclusion – Incentive Stock Options

Your financial goals are complicated and your ISOs only add to the level of complication. It’s important before exercising your ISOs and subsequently selling your stock to go in with your eyes open to how much tax you’ll owe as a result and whether it makes sense right now to exercise and sell. One small mistake and you could hurt your financial future. If you don’t have the confidence to feel good about each decision at every step of the way. Be sure to talk to a fiduciary financial advisor that specializes in helping high-earning individuals who have equity compensation like Progress Wealth Management and get the advice you need.