Incentive stock options (ISOs) are a form of compensation package awarded to key employees as a reward for achieving specific milestones, a vehicle to retain top employees, and an opportunity to share in the company’s success and align employees’ interest with the interest of the company.
ISOs can be a lucrative long-term compensation benefit, and a source of wealth accumulation, especially if you work for a high growth company with a rising stock price. Because ISOs may be highly valuable, there are special tax and financial components that are worth studying.
1 – What is an Incentive Stock Option?
An incentive stock option gives you the right to purchase shares of your company at a predetermined price during a predefined time frame.
You are given – or “granted” – a certain number of ISOs allowing you to buy – or “exercise” your options during a specific time frame – or when you are “vested”.
2 – What is the process of receiving ISOs?
When you are awarded ISOs from your company in a form of an option grant, normally, you will have to “accept” the option before it becomes official.
Your company, or your HR department will provide you with several documents which may include the stock option plan, the plan prospectus, and specific stock grant details. It is wise to read through the documents as they provide you with details about your rights, obligations, restrictions, and limitations.
The option grant letter will also provide you a vesting schedule. The vesting schedule specifies the time frame when you can exercise your stock options.
For example, a 12,000 ISOs with a monthly vesting of 1,000 ISO. Or a 5-year plan with a 20% vesting per year. This type of vesting schedules is designed to reward employees for staying with the company for a longer period, and it is also used as a retention tool to retain top employees. The stock option plan also details forfeiture provision should you leave the company before your ISOs vest.
3 – How do you exercise your Incentive Stock Options?
There are 3 strategies you can employ to exercise your ISOs. The approach you choose will depend on several factors such as: your cash flow position, short- and long-term financial goals, and your tax situation.
Exercise strategy 1 – Cash upfront
The simplest and easiest way to exercise ISOs is by paying with cash. When you exercise, you must deliver the cash to pay for the exercise cost of acquiring your company’s stocks. This is the best strategy if you are bullish on your company’s outlook, have the cash to exercise the ISOs, and want to maximize the number of shares you own.
In this example, you were granted 5,000 shares at an exercise price of $10 per share. You could choose to exercise all or portion of the 5,000 shares. Exercising all shares will require you to invest $50,000 of cash up front.
Exercise strategy 2 – Sell enough of ISO to cover exercise cost
You can convert by selling 1,000 share @ $50 each, you will receive $50,000. That is enough to pay for all your 5,000 shares leaving you with 4,000 remaining shares.
Exercise strategy 3 – Cashless Exercise
A cashless exercise can be designed in a way that:
- Can cover only the exercise cost of shares you need to purchase
- Can cover the exercise cost plus tax liability due on the exercise and the sale of stocks
4 – When Should I exercise my Incentive Stock Options?
Evaluating the pros and cons of exercising stock options is a topic where a financial expert can be invaluable.
Like most things in life, the decision to exercise is a judgment call. It is based on whether you need the money now, pay for kids’ education, supplement you income, or lowering your taxes now vs later. Another factor is your confidence in your company’s ability to grow and the share price to continue to rise, or the need for diversification since most ISO recipients tend to have a lion’s share of their wealth tied to their companies’ stocks.
You are considered an insider, an executive with inside knowledge of the company’s strategic plans and outlook, you may only be able to exercise within a specific time called trading window. If you are not sure of your status, you may want to consult your legal department before you exercise your ISOs or sell your common stocks.
5 – What are the tax implications of Incentive Stock Options?
There are two main tax possible outcomes related to the exercise. The tax treatment may be either a qualifying distributions or disqualifying distributions.
Qualifying distributions may help minimize your tax liability by adhering to a special holding period prior to the final disposition of stocks.
These requirements are:
- No disposition of stocks before the later of the following two dates:
- One year after the date you exercise your ISOs
- Two years after the date your employer granted the ISOs to you
A qualifying distribution entitles your profit to be treated as a long-term capital gain, which is taxed at a lower rate than ordinary income, which tends to be higher than long-term capital gain rate.
Disqualifying distributions occur when you exercise ISOs in a way that does not meet the rules of qualifying distributions. Example of such transactions that causes your ISOs to be a disqualifying distribution:
- Not satisfying the special holding period (listed above)
- A gift to someone other than spouse
- Using shares to exercise another incentive stock option
- Transferring your shares to an irrevocable trust
Certain events do not give rise to a disqualifying disposition:
- An exchange of shares that is part of a tax-free reorganization of the corporation that issued the shares
- A transfer that occurs as a result of death
- A pledge or hypothecation (meaning, using the stocks as a collateral)
- A transfer of stocks into joint tenancy
- A transfer to a spouse (or to a former spouse in connection with a divorce)
Not all disqualifying distributions are bad; sometimes it is beneficial to cause a transaction to be a disqualifying disposition. This can benefit you in case of a possible drop in stock price. In this case it may be a planning opportunity to avoid AMT tax!
Alternative Minimum Tax (AMT)
The alternative minimum is a parallel tax system to the regular tax system that was originally enacted to ensure that high-income taxpayers pay at least a minimum amount of tax if they benefit from certain deductions and other tax preference items.
ISOs fall under this parallel tax system where the spread between the exercise price and fair market value FMV is considered as a taxable income, although no cash is received (phantom income).
However, there are opportunities where you can exercise just enough ISOs to stay under the AMT radar. Sometimes it is beneficial to pay the AMT tax which will result in an AMT credit in future years.
In the event you are subject to Alternative Minimum Tax from the exercise of your ISO, you will need to file Form 6251 with your Form 1040.
Conclusion
Incentive stock options is a power wealth accumulation tool if you are a lucky recipient. They also can be a source of potential complication in the absence of a proper tax and financial planning.
If you have any questions regarding this article, or if you need further assistance regarding your unique financial or tax situation, send us an email at info@zagmoutcpas.com, or call us at (312) 239-3716.
To learn more, visit Zagmout & Company CPAs at www.zagmoutcpas.com.
