There are two types of employee stock options: incentive stock options, or ISOs, and non-qualified stock options, or NSOs.
Generally speaking, incentive stock options are the more complicated of the two. These complexities include holding requirements, potentially preferential tax treatment, and the alternative minimum tax.
You might find yourself with many questions about these important but often confusing parts of your ISOs. But before you dig too far into the complex aspects of your options, you’ll want to get a firm grasp of the fundamentals.
You need to know what you have, when you can do something about it, and when you option goes away. Having this information provides you with what you need to draft a strategy to incorporate your incentive stock options into your financial plan.
What Is an Incentive Stock Option?
An incentive stock option is a form of pay offered to an employee, often as part of a larger compensation package. ISOs can only be granted to active employees and can only be granted up to specific limits. The maximum annual limit is $100,000 of exercisable value (grant price times vesting shares).
ISOs allow you buy shares of stock at a predetermined price (the grant price) for a set period of time, regardless of the current market price. If the current market price is higher than your grant price, your stock options have value. If the current market price is below the grant price, your stock options do not have value.
Incentive stock options may also allow you to get preferential tax treatment as compared to non-qualified stock options. Paying less in tax, all else being equal, makes them the more valuable type of option.
Key Dates for Incentive Stock Options
They are several key dates that you should be aware of with your incentive stock options. They are important because they inform you of when you are given your incentive stock options, when you can exercise them, and when you no longer have the right to the option anymore.
These dates are known as the grant date, the exercise date, and the expiration date.
The grant date for your incentive stock options is the date you are given the shares. The grant date is also the date the shares are typically valued.
This value often determines the strike price. This strike price is the price you can buy shares of stock via your option. However, the grant date is not necessarily the time when you can exercise you option to buy the shares.
That date is your vesting date. Prior to the vesting date, you simply have a future promise. Once you reach the vesting date, you can act upon your option to exercise.
When you exercise, you turn paper-value into real value. Said another way, you can turn the value of your options into actual cash that can be used for whatever you want.
The vesting date is first date your options become available. The amount of options that vest on this date and subsequent dates are subject to the rules of your incentive stock option plan document.
Some plans allow for a fixed date when all your incentive stock options vest and others allow a certain percentage of shares to be vested over a rolling period of time.
One of the Most Important Dates to Note in Your Financial Plan: The Expiration Date
The final key date for your incentive stock options is the expiration date.
The expiration date is the final day that the you can exercise your right to buy your shares at the grant price. Should this date pass and you shares go unexercised, your options simply go away — and that could mean a big missed opportunity.
If you had 1,000 ISOs with a grant price of $2 per share and a current market value of $50 per share, that’s $48,000 of potential value…Let’s assume these options expire at the end of the day today. If you exercise today, you can buy shares and “capture” the $48,000 of immediate benefit.
Fail to exercise by the end of the day, however, and your option to buy the stock at $2 per share expires. Overnight, you forfeited the right to $48,000.
This is why it’s critical to have a plan in place so you can get clarity and understand what you’re supposed to do. Otherwise, you may not take any action at all because you don’t know what to do or feel overwhelmed by the process.
As we can see, failing to act can lead to a huge lost opportunity if you don’t act before your options expire.
What Happens When You Exercise Your Incentive Stock Options
When you exercise your ISOs, you’ll trigger a number of things that you’ll want to address
First, you need to pay for the shares you buy. The cost of the shares you buy is equal to the number of shares exercised, multiplied the grant price of the option.
Here’s an example:
- Number of Shares Exercised: 1,000
- Grant Price: $2.00 per share
- Current Share Price: $50.00
The cost of this exercise is equal to 1,000 x $2.00, or $2,000. In other words, you need $2,000 in cash to cover the cost of buying the shares.
You could pay that from your cash flow or savings. You may also be able to pay for the $2,000 expense by selling off some shares immediately after you exercise them, in a sell to cover or cashless transaction).
$2,000 might seem like a big chunk of change to fork over — but don’t forget the shares you’re buying for that cost are actually worth $50,000 in this example.
Still, in addition to the cost of exercising, you also create a reportable event for tax purposes. The bargain element, which is the spread between the grant price and the exercise price, will be included in your tax return for the calendar year of the exercise.
In our example, the bargain element is equal to the number of shares exercised multiplied by the (exercise price less the grant price). That’s 1,000 x ($50-$2), or $48,000.
The bargain element will be included on your tax return as either a tax preference item for calculating AMT or as ordinary earned income (not subject to Social Security and Medicare Tax). The actual tax outcome is subject to when you exercise, how long you hold the shares, and how far past the original grant date you may be.
Incentive Stock Options and the AMT
When you exercise incentive stock options, you could also wind up owing alternative minimum tax, or AMT. More specifically, if you exercise and hold ISO shares past the calendar year end you will likely need to address AMT.
AMT is an annual tax calculation run concurrently with your regular tax. The bargain element of exercised incentive stock options is included as income when calculating if you owe AMT.
In our example, your bargain element is equal $48,000. If we assume a flat AMT tax rate of 28%, we can calculate that you will owe $13,440 in AMT.
To summarize our examples, if you exercised and held 1,000 shares worth $50,000 (that you paid $2,000 for), you’d create an AMT bill of $13,440. AMT would be paid when you file your tax return in the year following the year of exercise.
A Qualifying Disposition of Incentive Stock Options
Even the basics of incentive stock options can leave one’s head spinning. So why go through all this mess?
The usual answer is because making the right decisions could make thousands of dollars’ worth of difference on your tax bill. If there’s a way to pay less tax and end up with more money, it’s worth exploring.
With ISOs, the gain from the grant price to the final sales price may be eligible for long-term capital gains treatment. To achieve this preferential tax treatment, you need to meet the standard for a qualifying disposition. That is:
- The final sales price is at least 2 years from the grant date and
- The final sales price is at least 1 year from the exercise date
To illustrate the potential value of a qualifying disposition using numbers, we can continue our example and assume a final sales price of $50 per share, a 33% ordinary income tax rate, and a 15% long-term capital gains tax rate.
We see the following:
|Ordinary Income||Capital Gains|
|Total Proceeds (1000 shares)||$50,000||$50,000|
|Total Gain (1000 shares)||$48,000||$48,000|
|Taxed as ordinary income (33%)||$16,000||$0.00|
|Taxed as capital gains (15%)||$0.00||$7,200|
The net proceeds from this hypothetical transaction favor capital gains tax, as illustrated through a qualified disposition.
(To be fair, a full analysis should include AMT tax paid as result of the original exercise, which may be a negative adjustment to the “capital gains” side of the chart. In our example, the negative adjustment would be $13,440 for AMT).
The AMT Credit for Incentive Stock Options
If your follow the transaction above, you will notice that you have paid tax twice on the spread between the grant price and the exercise price.
You first paid in the calendar year you exercise your options as AMT. You paid a second time as long-term capital gain when the final shares were sold. Are you really getting taxed twice?
Not with the AMT credit, which allows you to go back and get some (and possibly all) of the AMT paid due to exercise in the form of a tax credit.
When you sell shares from your previously exercised ISOs, you effectively undo what you caused you to pay AMT in the first place. When you undo this tax adjustment, the offset to the tax calculation may allow you to get AMT back in the form of a tax credit.
The exact details of AMT are complicated and require a personalized tax projection. How much and how quickly you could receive a will be determined by those tax projections.
The Basics of Incentive Stock Options Aren’t So Basic
Incentive stock options may be considered basic if you exercise and sell them immediately. But this may not be in your best interest because you may not be taking advantage of potentially preferential tax treatment, leaving you to pay more tax that you otherwise may need to if you meeting the holding requirements.
Beyond this simple exercise and sell strategy, stock options are anything but basic. Consequently, it makes sense to consult with an expert who has experience working with ISOs and the potential opportunities and pitfalls for your specific case. It’s worth getting a professional perspective so you can be sure you’re crossing your T’s and dotting your I’s in the best possible way.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts. None of the information in this document should be considered as tax advice.
The examples above are for illustrative purposes only and do not attempt to predict actual results of any particular investment.