Incentive stock options can be a major wealth creator for employees of startups. Many of the fastest-growing companies today are staying private longer, which means the public doesn’t have access to buy their stock. Included in the lucky few shareholders of these high-growth companies are the employees who either own stock outright or own stock options. While many of these companies eventually fade into oblivion, some go on to be worth billions of dollars, and the employee shareholders of those successful companies can end up with a very large financial windfall.
What are incentive stock options?
An incentive stock option (ISO) is a form of compensation that many startups grant to their employees. The ISO gives the employee the option (but not the obligation) to buy shares of the employer’s stock at a set price, called the exercise price.
If the market value of the employer’s stock is above the exercise price, then the ISOs have a positive value. The employee could theoretically exercise the option in order to buy the stock, then sell the stock and pocket the difference.
How do incentive stock options work?
The grant date is the date that your employer officially “grants” you the ISOs. It is an important date to know for tax purposes, which I’ll explain in more detail below.
Even if you’re granted options, you may not be able to do anything with them until they have vested. Vesting is when the rights to the options transfer to you and you can now act on them if you want to. Options can vest all at once or in chunks over time. The vesting schedule will outline how your options vest.
Once options have vested, you now have the ability to “exercise” them. Exercising your options means you’re going to pay the exercise price in order to own shares of stock in your employer. Each option entitles you to one share of stock in your employer, so you will need to pay the exercise price for each option you choose to exercise.
For example, if you own 1,000 options with an exercise price of $5, it will cost you $5,000 to exercise all 1,000 options. You may be able to do a “cashless” exercise if your employer’s stock is publicly traded. In a cashless exercise you exercise the options and immediately sell enough shares of stock to pay your exercise cost. The day you exercise your options becomes the “exercise date” for those options.
After you exercise the options, you now own shares of your employer’s stock. For publicly traded companies, you can choose to sell the shares or you can hold on to them and sell in the future. If your employer is still a private company, you usually have no choice but to hold the shares. The sale of your underlying shares triggers a taxable event. The difference between the sale price and the exercise price is what gets taxed.
Incentive stock options expire 10 years after they’re granted. If you don’t exercise the options before they expire, they’re gone. If the options are underwater, meaning the market value per share of the company is less than the exercise price, then letting the options expire could be the best option because you could buy the shares in the open market for less than if you exercised your options. However, if there is a positive equity value for your options, you want to watch the expiration date closely to make sure you don’t let the options expire unintentionally.
How are incentive stock options taxed?
One of the big advantages incentive stock options have over the other type of employee stock option (non-qualified stock options) is the tax treatment (for a comparison, check out this post). There is usually no tax due on your options at grant, vesting, or exercise (with the exception of AMT discussed below). The taxable event occurs when you sell the underlying shares after exercising your ISOs. The tax rate to apply depends on how long you held the shares.
If you sell your shares at least 2 years from the grant date and at least 1 year from the exercise date, the gain (the difference between the sale price and the exercise price) is taxed at more advantageous long-term capital gains rates. This is known as a qualifying disposition.
If you don’t meet the holding period requirements for a qualifying disposition (mentioned above) then the sale is called a disqualifying disposition and your gain is taxed as ordinary income.
Let’s look at an example to make this distinction clearer. Assume John was granted 1,000 ISOs on 6/1/2019 with a $5 exercise price. On 6/15/2020 John pays $5,000 to exercise all 1,000 options.
If John sells his shares the next day, 6/16/2020, for $50/share, his total proceeds will be $50,000 and his gain will be $45,000 ($50,000 minus the $5,000 cost to exercise). Because John sold his shares within 1 year of his exercise date, the sale is a disqualifying disposition and is taxed as ordinary income. We’ll assume John is in the 32% ordinary income tax bracket, which means when he files his tax return, he’ll owe $14,400 in tax for the shares he sold (32% x the $45,000 gain).
Let’s assume John holds his shares a while longer and sells them on 7/1/2021 for $50/share. He’ll have the same $45,000 gain, but because he held on to the shares at least 2 years from the grant date and 1 year from the exercise date, his sale is considered a qualifying disposition and he is taxed at his 15% long-term capital gains tax rate. Instead of paying $14,400 in taxes, he would only owe $6,750 on the sale.
Alternative Minimum Tax
There is a major caveat to the tax treatment of incentive stock options: the Alternative Minimum Tax (AMT). AMT is a parallel federal income tax calculation, which attempts to set a floor to the taxes people pay. The AMT calculation adds back some of the deductions and omissions the regular tax calculation allows. If your income for the year is above the AMT exemption amount, then your taxes get calculated twice; once under the regular federal tax calculation and once under the AMT calculation. If your tax owed using the AMT calculation is higher than your tax owed using the regular method, then you have to pay the AMT amount.
Most people don’t know AMT exists because the regular tax calculation typically results in a higher tax bill. However, incentive stock options can significantly change the equation.
How incentive stock options affect AMT
While the regular tax calculation ignores any incentive stock options you exercised but didn’t sell that year, the AMT calculation does not. If you hold your ISOs across the calendar year after exercising them (i.e. you exercise in 2020 and haven’t sold the underlying shares before 1/1/2021) then you are at risk of paying AMT. The difference between your exercise price and the fair market value of the shares on the date of exercise is known as the bargain element, and it’s added to your income for the purposes of calculating AMT.
If you are considering holding your ISOs to get more favorable capital gains tax treatment when you eventually sell, you need to know how much bargain element you can carry across the calendar year without triggering AMT. This amount is known as the AMT crossover. One common strategy for individuals with ISOs is to only exercise their ISOs up to the AMT crossover so they don’t trigger AMT. Ultimately, it may make sense to pay AMT in order to get capital gains tax treatment down the road and if that’s the case, you need to be prepared for the bill coming at tax time.
Continuing the example above, we’ll assume that when John exercised his ISOs on 6/15/2020, the fair market value of his employer’s stock was $50/share, which means his bargain element was $45/share, or $45,000 total. By holding his shares across the calendar year, that $45,000 gets added to his income in order to calculate AMT. The AMT calculation is complex, but we’ll assume John is in the 28% AMT bracket and owes AMT on the full $45,000. That means he will owe an extra $12,600 in taxes before he has ever sold the shares of his employer’s stock. John may be able to claim an AMT tax credit in future years to get some of that AMT paid back.
Bringing it all together
The ideal strategy for ISOs is a balancing act considering the potential payout of owning stock in a high-growth company, the risk of concentration in a single stock, and the tax consequences. ISOs can be extremely valuable and a great way to build long-term wealth, but they are very complex. It’s worth talking to a qualified professional who can help you to understand the situation and come up with a personalized strategy that fits your financial goals.