Incentive stock options are a wonderful benefit to receive. They’re often granted to executives of publicly traded companies and early stage employees of startups, in an effort to align their interests more closely with shareholders. They’re also more complicated than their close cousins, non-qualified stock options thanks to certain tax advantages. The timing of when your shares vest, when you exercise, and when & whether you sell the resulting shares determine how your options are taxed & whether these advantages will apply. This post will cover the basics of incentive stock options, how they’re taxed, and a few points to consider if you’ve been granted them.
The Basics of Incentive Stock Options
Stock options give holders the right to buy or sell a certain security at a certain price for a certain period of time. You can buy and sell stock options on thousands of publicly traded stocks through a typical brokerage account. Incentive stock options are the same basic contract, where you’re given the right to buy a certain number of shares of your company for a specific dollar amount. Here are a few basic terms you’ll need to know.
Strike Price: This is the price at which you have the right to purchase shares. This is often discounted from the current market price.
Fair Market Value: Fair market value (FMV) reflects the value of a company’s shares at any given time. This is easy to ascertain for large, publicly traded companies since their equity value is constantly being traded over exchanges. FMV for a given day is simply the average of the high and low selling prices on a particular trading day. For privately held businesses, FMV is typically determined by a formal appraisal or business valuation.
Vesting: Vesting is the concept of your options becoming “active”. Often companies will issue stock options that vest over time. This incentivizes employees to stick around and continue building the value of the company. A common vesting schedule might be 25% over four years. This means that if you’re issued 1,000 options, 250 will be available for you to exercise one year after the grant date. Another 250 would vest after two years, and so on. Another common schedule for ISOs is a three year cliff, where none of the options vest for the first three years. Then when the three year date arrives, 100% vest.
Grant Date: This is the date the company gives you the options initially. Vesting “clocks” start ticking on the grant date.
Expiration Date: This is the date the options expire. Note that sometimes expiration is triggered upon resignation or termination of employment. Usually you’ll have 90 days after leaving to exercise your options, but this isn’t always the case.
Bargain Element: The difference between the fair market value of the shares and your strike price is the bargain element.
Qualifying Disposition: If you sell ISO shares at least two years after the grant date and one year after exercising, it’s considered a qualifying disposition. This comes with favorable tax advantages.
Disqualifying Disposition: Any sales of ISO shares that are not considered qualifying dispositions are considered disqualifying dispositions. Disqualifying dispositions are taxed differently.
Let’s say that your employer gave you 1,000 incentive stock options three years ago that just vested. The strike price (exercise price) is $10, and equity shares of your company currently trade over an exchange at $25. The bargain element works out to $15 per share: $25 – $10. Even though shares of your company might cost $25 on the open market, your ISOs give you the right to buy them for $10. If you exercised your options and hung onto them for one year, you could then sell the shares in a qualifying disposition. Exercising and immediately selling would be considered a disqualifying disposition.