Founder and Principal Financial Advisor, Progress Wealth Management
What are ISOs?
If you work in tech, you’ve probably heard of ISOs, NSOs, ESPP, RSUs, and NQSOs. Companies often offer stock as part of your employee compensation package when they offer you a job for a number of reasons but the most common reason is, that they hope to retain you more effectively and it’s more affordable to pay you in stock than it is in extra cash. They usually issue incentive stock options (ISOs), non-qualified stock options (NSOs), or restricted stock unit (RSUs). These mainly differ by how/when you have to pay taxes and whether you have to purchase the shares.
ISOs are a type of stock option that qualifies for special tax treatment. Unlike other types of options, you usually don’t have to pay taxes when you exercise (buy) ISOs. Plus, you may be able to pay a lower tax rate if you meet some specific requirements of the IRS.
A stock option is a right to buy a set number of shares at a predetermined price—usually, the market value of the shares when granted to you. This price is set by a 409A valuation and is often called your “strike price“ or exercise price.
If the value of the share increases over time, you can make money on the difference between your fixed purchase price and the sale price (fair market value when you sell it), or “the spread.”
How Do Option Grants Work?
When you’re offered a job in tech, oftentimes you’ll receive some form of equity in addition to a salary. The equity’s purpose is to help retain you for longer and it’s important for employers to offer this because tech is such an incredibly competitive market. Typically, your grant date will be in the same calendar year as your start date for your new job and normally your employer will offer you some type of stock options or equity or some specific quantity of the company’s stock (Restricted Stock Unitss).
The main differences between Stock Options and Receiving Company Stock
If you receive some form of stock options, you’re essentially receiving the “option” to buy at either the predetermined purchase price or the market price (buy at the lower price of the two) you’re given by receiving stock options. They typically carry with them an expiration date for the option holder as well so, if you hope to buy the stock using the stock option, you’ll have to do it before the time is up. This expiration date is typically 10 years following the grant date. Normally stock options have preferential tax treatment over receiving company stock.
Receiving company stock is literally receiving stock in the company you work for without having to pay for it. You’ll receive a specific number of shares at some grant price that you won’t have to pay for upon getting your job offer that will vest at a predetermined date in the future. When they vest, the full amount worth of stock is taxable income to you which could be a huge tax day, however, the benefit is, there’s guaranteed value when you receive company stock. That’s not always the case with stock options. The tax rate you’ll be charged is the same you’ll pay on your regular income, ordinary income taxes, and like I mentioned, this is based on the stock’s value at the time it vests.
Normally, you can’t buy all of your shares right away and have to work for the company over time to be able to purchase your shares. This is called a vesting schedule. You can exercise your stock as soon as your options have vested, but you’re never required to exercise.
In some cases, you might be able to exercise your options before they vest. You can check your option grant or ask your company to see if they allow early exercise. Note that this may result in a taxable event, so also consult with your tax advisor or financial planner before you exercise. They’ll guide you on how to think about this major decision.
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When do incentive stock options expire?
Typically, ISOs expire 10 years from the date you’re granted them, however, your company might enforce a post-termination exercise (PTE) period that gives you a shorter amount of time to exercise options after you leave the company. If you don’t exercise them before that period ends or before they expire, you’ll lose the opportunity to purchase them.
Even if your company gives you a long time to exercise ISOs after you leave, if you don’t exercise them within three months of leaving, they’ll lose their ISO tax treatment and will be taxed like NSOs.
When can I sell my shares?
You have to exercise ISOs and purchase shares before you can sell your shares. If you choose to exercise, you usually have two options: pay for the total in cash or do a “same-day sale”—in other words, sell a portion of your shares to cover the cost of exercise.
Selling to cover exercise costs is called a “cashless” exercise. It’s less risky because you haven’t invested your own money. However, selling shares right after exercising prevents you from taking advantage of ISOs’ favorable tax structure. Not all companies allow cashless exercises, so check to see if yours does before exercising and check with your tax advisor in general.
How are incentive stock options taxed?
There are two types of tax to consider with equity compensation: ordinary income tax and capital gains tax. The capital gains tax rate has historically been lower than the ordinary income tax rate.
One time you may have to pay taxes is at the time of exercise, When you exercise your ISOs, you don’t have to sell the resulting shares right away. If you do sell right away (for example, to cover the cost of exercise), the shares you sell won’t qualify for the ISO tax advantage. Instead, they’ll be taxed like NSOs and you’ll pay ordinary income tax on the spread between your strike price and the FMV at the time of sale.
If you exercise ISOs and hold your stock for at least one year following the date of exercise, your stock should be eligible for the tax incentive when you sell (only pay long-term capital gains tax). To receive the incentive, you must hold (keep) ISOs for at least one year after exercise and two years after the grant date.
- If you hold your stock for at least a year after purchase, you will pay the lower capital gains tax rate on the increase in value (long term capital gains) as opposed to ordinary income taxes (. However, you may be subject to the alternative minimum tax (AMT) when you exercise. Talk to your tax advisor to see if AMT might impact you. Typically, it only affects high-income earners.
- If you sell your stock right away, you will not experience any capital gain and therefore will pay ordinary income tax rates on the portion that you exercise and sell.
What happens to my Stock Options if I lose my job, die or quit?
Upon the termination of employment, you typically have a short period of time to exercise your stock options if they’re in the money (aka, the fixed price you can buy at is lower than the fair market value of the shares). Normally this is 90 days so be sure you don’t forget. You could potentially be leaving literally hundreds of thousands of dollars on the table.
DISCLOSURE: Progress Wealth Management (“PWM”). This communication is for informational purposes only and contains general information only. PWM is not, by means of this communication, rendering accounting, business, financial, investment, legal, tax, or other professional advice or services. This publication is not a substitute for such professional advice or services nor should it be used as a basis for any decision or action that may affect your business or interests. Before making any decision or taking any action that may affect your business or interests, you should consult with PWM, a tax professional, or another fiduciary financial advisor. This communication is not intended as a recommendation, offer, or solicitation for the purchase or sale of any security. PWM does not assume any liability for reliance on the information provided herein.