What are Incentive Stock Options?
Incentive Stock Options, otherwise known as ISOs, are a type of stock compensation that are common in the tech world. It can get really confusing, but this video & blog post should help clarify things so that it makes a little bit more sense for you.
In order to understand ISOs, we can break them down into three main stages:
They are granted to you
You exercise them
You sell them
Your ISO Grant
Congratulations! Your company likes you enough to give you the opportunity to participate in its growth.
When you are granted ISOs, you now know a few key pieces of information:
Grant Date - The date that the ISOs are… um… granted to you.
Number of ISOs - I think you can guess what this one means, too.
Exercise Price (a.k.a. Strike Price) - The cost of turning 1 ISO into 1 share of stock.
Vesting Period - The requirements that you have to meet in order to be able to take action on the ISOs. This is either based on time, performance, or a combination of the two.
Expiration Date - The last date that you have to decide to exercise the ISOs. A common expiration date is 10 years from the grant date. Once this passes, then any unexercised ISOs go “poof”!
Let’s work through an example: You are granted 1,000 ISOs at a $10 exercise price. All of the ISOs vest in 1 year.
Exercising ISOs
Once you have satisfied the vesting requirements, you now have the choice to exercise any vested ISOs. Remember, “exercising” is simply the act of turning an ISO into an actual share of stock.
Why did I underline that it’s a choice? Because sometimes it simply doesn’t make sense to exercise, depending on the exercise price compared to the current stock price.
Put another way, think of an ISO as a coupon that says “Buy One Big Mac for $7”. But if your local McDonald’s is selling Big Macs for $5.50, then your coupon is essentially worthless. It’s cheaper to just buy the thing (disregarding how gross you’re going to feel afterward).
If the current stock price is lower than the exercise price, then your ISO is “out of the money” and no better than a $6 Big Mac coupon.
But if the current stock price is higher, then your ISO is “in the money” and has inherent value.
In our example, let’s say the current price is $20 per share. That’s a good deal because we can pay $10,000 (1,000 x $10/share) to buy something that is worth $20,000 (1,000 x $20/share).
To sound cool, you’d say you’re “$10,000 in the money” ($20,000 value - $10,000 cost to exercise).
And to sound extra cool, that $10,000 spread is also called the bargain element. This is important.
When To Sell (and the related tax implications)
At this point, you’re now the proud owner of 1,000 shares of stock in your company. The final decision to make is when to sell your stock.
Disqualifying Disposition
This is just a fancy way of saying that you didn’t hold on to the shares long enough to “qualify” for special tax treatment (which I’ll explain in the Qualifying Disposition segment).
The most straightforward scenario is the “Exercise & Sell” option, meaning that you’re selling your shares immediately after exercising in one motion. This will lock in your gains and you’re now free to use that money for other items, such as a home down payment or family vacation.
But before you go spending all that money, you need to know how it’s taxed. Your employer won’t be withholding anything from this, so the responsibility falls on you to know how much to put aside to pay the taxes.
In a disqualifying disposition, the bargain element is taxed as ordinary income.
In our example, that means that you’ve just received $10,000. If you’re in the 32% tax bracket, you’ll need to put aside $3,200 for federal taxes (+ however much is needed for state taxes, too).
Qualifying Disposition
The nice thing about ISOs is that there is an opportunity to get a pretty nice tax break, given you satisfy two rules.
Hold onto the shares > 2 years from the grant date
Hold onto the shares > 1 year from the exercise date
Doing this means that the bargain element and any additional gains are ALL taxed at preferential long-term capital gains rates.
In our example, let’s say that we’ve waited that long and in that period the stock price is now at $25 per share.
Selling at this point would mean that you would have a $15,000 gain ($10,000 bargain element + $5,000 capital gain). Since this is a qualifying disposition, we’d be paying at a 15% tax rate instead of 32% which translates to $2,550 saved on federal taxes.
What Is This AMT Business?!
Remember how I said the bargain element is important? Here’s where it comes into play.
If you exercise ISOs and hold them through the end of the calendar year, then the associated bargain element is taken into account in the Alternative Minimum Tax calculation. In other words, you may owe additional taxes. And since you’re holding onto the shares, that money may need to come from somewhere else.
(Side note, one strategy is to exercise early in the calendar year so that you can satisfy the qualifying disposition rules and still sell your shares in time to pay the AMT tax bill)
The good news is that the extra AMT paid can usually be recouped through AMT credits when filing taxes in future years.
Conclusion
The example that I’ve used is admittedly an ideal scenario where the stock price has continually gone up, but we know that this is not always the case. The decisions on when to exercise & sell your ISOs require taking a lot of other factors into account as well.
Do you have an immediate need for the money?
Are you willing and able to take the risk of holding stock in the company that is also your source of income?
What is your expected tax bracket now and in the future?
If you have this situation, I would highly recommend reaching out to a financial professional who specializes in stock compensation to help walk with you and figure out what’s best for you.
