Incentive stock options (ISOs) are a powerful wealth-building tool. They can provide an opportunity to lock into your company’s growth potential early then reward you with future tax breaks. Let’s take a deep dive into ISOs and learn everything you ever wanted to know about ISOs!
ISOs may be a golden ticket to wealth and tax breaks; however, these tax breaks don’t come without some hurdles. ISOs must meet strict Internal Revenue Code (IRC) requirements to qualify for this elite status. Not to worry though; these stipulations are fulfilled by your company, not yourself. Furthermore, not all companies offer ISOs, so if yours does, consider yourself one of the lucky few.
What’s The Big Deal About ISOs?
If certain holding requirements are met, the appreciation in value of your ISOs from the time you exercise them is subject to lower, long-term capital gains rates. If you hold your ISOs for a minimum of two years from the grant date and a minimum of one year from the exercise date, the gain on sale of your ISOs will receive this favorable tax treatment. This could be a significant tax savings, especially if your stock experiences a windfall during this time. At the highest tax rates, you’re looking at a 20% tax rate compared to 37%. (This article will not be addressing other potential tax liabilities such as state taxes or the net investment income tax. It is best to consult with your tax and financial advisors regarding your specific tax situation.)
To be clear, however, ISOs are not a get rich quick scheme. Depending on your grant and your company’s valuation, you will likely need a large cash coffer in order to take advantage of any tax savings. You will need these funds to cover the exercise and possible alternative minimum tax (AMT) before you can reap any tax benefits. To illustrate, let’s talk about how ISOs work.
How Do ISOs Work?
Like other stock options, your company offers you ISOs through a formal grant. Typically they offer you a sum of ISOs that will gradually become available for exercise over a span of time, through a process known as vesting. Your ISOs may vest annually, quarterly or even monthly.
Once your ISOs vest, you can exercise them if you choose. Depending on your financial goals, there are different approaches to exercise your ISOs.
- Pay cash to exercise, then retain all shares.
- Exercise and sell some shares to cover the cost of exercising, then retain the remaining shares.
- Exercise and immediately sell all shares.
Each scenario has a slightly different tax consequence. Scenario 1 provides the most optimal tax benefit for you, but it also requires the most cash outlay. Alternatively, Scenario 3 offers the least advantageous tax result, but it provides an immediate and sometimes sizable cash flow. Scenario 2 falls somewhere in the middle. Let’s dive into each scenario with an example.
Assume you were granted 40,000 ISOs with an exercise (strike) price of $5/share. Assume the fair market value of the stock on the day of exercise is $20/share.
10,000 shares have vested, and you wish to exercise all of them. You pay $50,000 cash and hold all of the shares for optimal tax treatment.
10,000 shares have vested, and you wish to exercise all of them and sell some to cover the cost of the exercise. You need to sell 2,500 shares to cover the cost of the exercise, while you retain 7,500 shares.
10,000 shares have vested, and you wish to exercise and sell all shares (also known as a same-day sale). You sell all 10,000 shares at $20/share for $200,000 reduced by transaction fees and the cost of the options.
As you can see:
- Scenario 1 leaves you with a cash deficit.
- Scenario 2 leaves you with a cash neutral position.
- Scenario 3 leaves you with a cash surplus.
Tax Implications After Exercise
Let’s review what happens at tax time after your exercise.
Generally, an exercise of ISOs does not trigger any “regular” tax due in the year of exercise. However, depending on your overall income, you may be subject to AMT. You will only owe AMT whenever your AMT liability is greater than your regular tax liability. ISOs can trigger AMT because the spread from exercise (the difference between fair market value on the exercise date and the exercise price) is a positive adjustment (increase) to your alternative minimum taxable income. Let’s assume here that your AMT exceeds your regular tax liability by $20,000. This amount is due when you file your tax return for the tax year in which you exercised the ISOs.
The good news about AMT triggered by ISOs is that the income recognized for AMT purposes is only a temporary timing adjustment. As you’ll see later, paying AMT now functions as a prepayment for future taxes on your ISOs. The $20,000 AMT carries over as an AMT credit to be used in future years when your regular tax exceeds your AMT. Generally, you’ll be “refunded” your AMT in the year you sell your ISOs. (There are situations however, that could leave you with “too much” AMT credit. It’s important to do careful tax planning to avoid these situations.)
When you sell and hold ISOs, you may see both AMT and regular tax implications. When ISOs are sold prior to holding period requirements (two years after grant date and one year after exercise date), this is called a disqualifying disposition. In this instance, the ISOs are treated just like nonqualified stock options (NQSOs or NSOs). This means you recognize ordinary (wage) income equal to the spread (difference between the sales price and your exercise price). In our example, your ordinary income is $37,500 (2,500 x ($20 − $5)). Assuming you’re in the highest marginal tax bracket, you would owe about $14,000 in taxes on this amount
Additionally, depending on your overall income, you may be subject to AMT on the 7,500 shares you kept. Let’s assume you end up owing $7,000 in AMT.
When you sell all of your ISOs, the entire transaction is a disqualifying disposition. In our example, you recognize $150,000 of ordinary income (10,000 x ($20 − $5)). There is no AMT that is due under a disqualifying disposition. At the highest marginal tax bracket, you would owe about $55,000 in taxes.
Unsurprisingly, a disqualifying disposition yields the highest tax liability in the year you exercise.
Tax Implications of a Qualifying Disposition
A year has gone by, and perhaps you’ve grown a few gray hairs while weathering the risks of your concentrated stock position. Still, your patience has paid off, and you’re finally ready to reap the rewards. Let’s assume you have met the ISO holding requirements for a qualifying disposition and you sell your ISOs. The stock is now worth $40/share.
Your net gain from the sale is $350,000 ($400,000 proceeds − $50,000 basis). If you are in the highest capital gains bracket, your tax liability will be about $70,000. The exciting caveat is that in most circumstances, this is when you will also liberate your AMT credit. Let’s assume you can now recover the $20,000 in AMT that you paid upon exercise. This yields a net tax liability of $50,000.
Your net gain from the sale is $262,500 ($300,000 proceeds − $37,500 basis). If you are in the highest capital gains bracket, your tax liability will be about $52,000. Like Scenario 1, you will likely be able to claim your prior AMT as a credit. With a $7,000 credit, this leaves your net tax liability at $45,000.
There are no tax implications under Scenario 3 because the stock was already sold.
As you can see, Scenario 1 results in the highest tax liability once the ISOs are finally sold, while Scenario 2 is not far behind.
Which Strategy Is the Winner?
The best strategy depends on your own personal financial goals. It’s best to work closely with your financial and tax advisors to devise the best course of action. There are also other nuances to ISOs that have not been discussed here that could be utilized to your advantage. To wrap up our example, let’s look at the total taxes paid and total cash in / out for each scenario.
You’ll see Scenario 1 requires the greatest outflow of cash between exercise and taxes, but provides the largest net gain. It’s clear that Scenario 3 is the least ideal because it offers the lowest net gain. Although, there are certain circumstances in which you would want to pursue Scenario 3. For example, if the future value of your company’s stock looks bleak, it might be better to offload your acquired shares sooner rather than later. Additionally, this enables you to diversify your portfolio instead of having a large concentrated stock position in your company, which can be risky, especially in a volatile market. The beauty of ISOs is their versatility. Whatever your present or future goals are, with qualified professional advice, you can plan your exercises and sales to help you achieve them.