By: AnnaMarie Mock, CFP®
What is an Incentive Stock Option?
An incentive stock option (ISO) is a form of equity compensation where the employee has the right to buy shares of the company at a discounted price with special tax treatment.
An ISO is a long-term incentive that replaces cash compensation and encourages employees to contribute to the company’s growth and development, hoping the options grow in value over time.
ISOs Have Two Important Dates
These dates are the Grant Date and the Vesting Date(s).
The Grant Date is when you are issued the option at a set price called the strike price. The Vesting Date(s) is when you have the right to exercise the options.
Exercising options allows you to purchase the shares at the strike price. Once it’s exercised, you have the choice of either selling the stock immediately (disqualifying event) or holding on to it for a set period (qualifying event). Each event has different tax implications associated with it.
Example: Mary was granted 1,000 ISOs with a strike price of $5. The options vest over four years, 25% each year. In year 1, Mary will have the option to exercise 250 shares, which would result in a cost of $1,250 (250 shares x $5 strike price). There are two paths Mary could take (1) sell immediately (disqualifying event) or hold on to it (qualifying event).
Disqualifying Event: After Mary exercises the options, she immediately sells the 250 shares at $10/ share. The market value of the sale is $2,500 (250 shares x $10/ share), and her cost basis is the amount she paid to exercise it, $1,250. Mary will recognize the difference between the sale and strike price ($2,500 - $1,250) as ordinary income.
Qualifying Event: Mary exercises the 250 shares in year one but wants to meet the requirements for the qualifying event to get preferential tax treatment. A qualifying event means that the gains are taxed at capital gains rather than ordinary income, resulting in significant tax savings for high-income earners.
Long-term Capital Gains
You must hold your ISO for more than two years from the grant date and one year from the date of exercise to receive long-term capital gains treatment.
Grant Date: 1,000 Year 1: Exercise 250 Year 2: Sell 250 Shares
As shown above, Mary meets the holding period requirements, so the sale proceeds are treated as capital gains instead of ordinary income at the end of year 2.
A qualifying event involves more steps and a lengthier holding period, so why would anyone consider it? Below is a comparison of the tax liability for a disqualifying and qualifying event. Assume Mary is in the 32% ordinary income tax bracket and 15% capital gains bracket.
Although it takes an additional year to divest the ISOs, Mary saved about $1,900 in taxes by deploying that strategy!
Alternative Minimum Tax and ISOs
Word of caution with ISOs: Exercising ISOs do not result in an ordinary income tax event but can affect the alternative minimum tax (AMT) calculation. AMT is a different way of calculating the total tax liability, ensuring that higher earners pay the appropriate taxes.
In the year you exercise ISOs, the difference between the strike price and market value of the stock is income for AMT purposes, which may increase your total taxes for the year. For example, when Mary exercised her 250 shares in year one, she did not owe federal taxes, but she recognized $1,250 income for the AMT calculation.
ISOs are an excellent addition to an investment and compensation plan, but they can come with an unexpected tax bill that can be disastrous if not handled properly. I recommend engaging your advisor and accountant to review the options available for your ISOs or any type of equity compensation plan.
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AnnaMarie Mock is a CERTIFIED FINANCIAL PLANNER™ and Partner at HIGHLAND Financial Advisors, LLC, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, employer retirement planning, and investment management. AnnaMarie graduated from Montclair State University with a degree in finance and management and successfully passed the CFP® national exam in 2016. She has been working at Highland Financial Advisors since 2013 as a fee-only, fiduciary Wealth Advisor and is a member of NAPFA.