How are Incentive Stock Options (ISOs) Taxed?

How Are Incentive Stock Options Taxed?

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.

 

Example:

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.

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Episode 48: The Three Golden Rules of Investing

A Beginner’s Guide to Factor Investing

This week on Grow Money Business we dive into another fascinating investment strategy: factor investing. Factor investing is a strategy that focuses on selecting securities based on attributes that are linked to higher returns. Throughout this episode, Grant covers what factor investing is, how you may implement it in your investment efforts, and some of the things you should keep in mind when engaging in factor investing. Stay tuned until the end of the episode, where Grant shares some valuable tips for minimizing your risks.

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How Are Non-Qualified Stock Options (NSOs) Taxed?

How Are Non-Qualified Stock Options (NSOs) Taxed?

Non-qualified stock options (NSOs) are a very popular way to compensate employees at publicly traded companies, and a wonderful benefit to receive.  But the tax consequences, and how to handle them, can be confusing.

How you handle an NSO grant should depend on your personal financial situation: your objectives, your tax situation, your cash needs, the rest of your portfolio, etc.  Managing your NSOs thoughtfully can lead to a huge tax savings over time.  Managing them haphazardly can lead to an unwanted (and unneeded) bill to the IRS.

This post will cover how NSOs are taxed, and a few questions you should ask yourself before deciding how to handle them.

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Episode 48: The Three Golden Rules of Investing

Grow Money Business Episode #45: Emotions & Money Messaging With Mariah Hudler

Hi everyone –

As you may know, I launched a podcast last December called Grow Money Business.  Thus far we’ve been hosting the episodes on Libsyn, and posting them each week to growmoneybusiness.com.

This week we’re starting something new.  Rather than posting new episodes to growmoneybusiness.com only, I’m going to start posting them here as well.  If you’re hearing about the podcast for the first time, you can check out the first 44 episodes on growmoneybusiness.com if you’re interested.

Enjoy!

 

In today's episode we have another distinguished guest: Mariah Hudler. Mariah is a financial therapist who helps people build balanced, comfortable relationships with money. Throughout this episode, Mariah shares her wisdom about what contributes to our attitude toward financial matters, how our backgrounds impact our financial decision making, and what you can do to improve your relationship with money. Stay tuned until the end of the episode, where we talk about some valuable tips for reducing financial stress.

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Mutual Funds vs. ETFs: What's the Right Investment Vehicle For You?

Mutual Funds vs. ETFs: What’s the Right Investment Vehicle For You?

Sound investment management always starts with asset allocation.  The biggest decision you can ever make as an investor is the portion of your assets you invest in stocks.  This decision alone is responsible for around 90% of the returns you’ll see over the years in your portfolio.  The other 10% is based on whether you’re investing in U.S. stocks or international stocks, large cap or small cap, and value or growth.

Once you decide the proper allocation for you and your family, the next step is to select specific investments to buy.  Maybe that’s an S&P 500 index fund.  Perhaps it’s a small cap value stock fund.  Whatever the asset class, if you choose to invest in a fund you’ll have two predominant choices: a mutual fund or an exchange traded fund (ETF).

Both can be great investment vehicles, but they are very different animals.  Making a sound decision surrounding which vehicle is best for your strategy is important, and one that many investors overlook.

This post will describe these differences, and how to determine which investment vehicle is right for you.

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Biden's Tax Plan

Reviewing the Biden Tax Plan

With the election in November creeping closer, the campaign season is now in full swing.  And the closer we get, the more details & campaign promises start to emerge from the candidates.

Biden’s tax plan has mostly flown under the radar in the national media thus far, thanks to the global pandemic.  But given that he has at least a 50/50 shot at winning, I thought it made sense to devote a post to what he has in mind if he does win the Presidency.  If elected, we could see some substantial changes to the tax code in the next few years.

Here’s the rundown.

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Buy/Sell Agreements Make the Best Insurance Policies

Buy Sell Agreements Can Be the Best Insurance Policies

Risk management is a pretty common objective for small business owners.  Once a business becomes viable, protecting what you worked so hard to build is usually a priority.  As COVID-19 has shown us, so many things could go wrong in the life cycle of a small business that it makes sense to limit risk wherever possible.

The first place many business owners will look is to the insurance industry.  Errors & omissions, malpractice, general liability, and standard business owner’s policies can be great ways to limit risk in specific areas of your business.  Insurance usually won’t help you much with planned or unplanned successions, though.

What happens when it’s time to retire?  Who might be willing to buy your stake in the business?  How do your partners feel about that?  How will your business be valued at the time?  And what happens if you’re forced into retirement involuntarily?

This is where buy sell agreements come into play.  They may seem mundane, but buy sell agreements are an important component of risk management in any small business.

In our financial planning practice there are a few common mistakes we see with buy sell agreements.  This post will cover those mistakes, as well as the standard provisions we tend to see in effective agreements.

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Don't Take Those RMDs This Year!

Don’t Take Those RMDs This Year!

As you may have heard, the CARES Act (aka the Coronavirus stimulus bill) created a holiday for mandatory distributions from retirement accounts in 2020.

So if you’re otherwise required to pull money from your IRA or 401(k) this year, you can skip it – penalty free.  This includes retirement accounts of your own AND those inherited from someone else.  Pretty neat, right?

But remember, the CARES Act wasn’t passed until March.  What if you’ve already taken a distribution?  Can you put it back?

The good news is yes, you can, as long as it’s done by August 31st.  Whereas this wasn’t initially the allowable, updated guidance from the IRS says that those of you who took RMDs in January or February can now replace them.

Read on for the details on how to put back your RMD if you’ve already taken one, and when you might still want to take a distribution if you haven’t already.

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Q2 Market Update

Market Update: Q2 2020

Well that was an interesting quarter.  The second quarter of 2020 brought us the fastest selloff into a bear market in history, which subsequently turned out to be one of the shortest in history.  Equities around the world continue to whipsaw investors amid COVID-19 and the resulting fiscal and monetary stimulus packages from governments around the world.  In short, the markets seem to be at odds with the economy.

Interest rates have fallen in lockstep and show few signs of rising any time soon.  This makes for great refinancing opportunities for borrowers, but poor bond yields for long term investors.  These are interesting and precarious times.

Here is this quarter’s market update.

Q2 Market UpdateQ2 Market Update

Q2 Market Update

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Your Business Is An Investment

Your Business is an Investment

Quick anecdote to kick off today’s post.

In a small town in the midwest there are two plumbers: Jim and Jason.  Both are 50 years old, and both are married with two kids who will someday go to college.

Jim and Jason are both great at their trade.  They are available when needed, charge a fair price for stellar work, and are well liked in the community.  They have the exact same number of customers in any given year, and both produce the exact same amount of revenue.

Their interest in building their respective businesses is where they differ.  Not from a revenue or growth standpoint, but from an operational standpoint.  Hiring & training support staff and new plumbers.  Systematizing and building process efficiencies.  Jim is hell bent on streamlining his business in an attempt to organize & simplify his work.  Jason is uninterested – he cares more about the customers and the work, and doesn’t mind when his professional world is hectic.

Now let’s fast forward 15 years.  Jim and Jason have brought in the exact same amount of revenue over the last 15 years.  But Jim has been far more efficient with how that revenue has been distributed.  He has systems, procedures, and operations built out to where his only duty is jumping in the car and driving out to see his customers.  Because of that he’s been free to spend more time with his family, and has packaged his business in a way that’s attractive to buyers.  He could sell to his employees or another party, and reap the value of the enterprise value he’s built.  The funds will contribute to his lifestyle in retirement.

Jason is ready to retire, but hasn’t been able to squirrel enough funds away to stop working.  He’s not been able to delegate much of his work to employees, and has virtually no systems or processes in place.  He realizes that in order for someone else to take over his business they would need to spend time – at least a year – working side by side to understand how he has everything set up.  Jason’s had to work twice as hard to produce the same revenue as Jim.  He’s enjoyed far less time with his family and his health has suffered.

It’s not surprising that a tightly run business creates more value.  What is surprising to many small business owners is the fact that failing to tighten up operations could be the difference between capitalizing on years of hard work by selling versus walking away with nothing.

Which gets us to the point of today’s post: your business is an investment.

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