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.

Continue reading

Top Strategies for Managing Incentive Stock Options

Top Strategies for Managing Incentive Stock Options

Incentive stock options, or ISOs, are a pretty common way for companies to compensate management and key employees.  Otherwise known as “statutory” or “qualified” options, ISOs are a way to give management a stake in the company’s performance without doling out a bunch of cash.

While they can have wonderful tax benefits, far too many people who own ISOs fail to exercise them wisely.  Some estimates even claim that up to 10% of in the money ISOs expire worthless every single year.  If you own incentive stock options but aren’t sure how to manage them, read on.  This post will cover a few of the top management strategies at your disposal.

Continue reading

Employee Stock Options 5 Top Mistakes that Leave Money on the Table

Employee Stock Options: The Top 5 Mistakes That Leave Money on the Table

Employee stock options can be a wonderful form of compensation. Unfortunately, far too many employees leave money on the table when managing them. Here are the top five mistakes you should strive to avoid:

 

1) Underappreciating Tax Liabilities

There are two types of company stock options: incentive stock options (ISOs) and non-qualified stock options (NQSOs). They differ in structure, who they’re offered to, and how they’re taxed. Here’s a good review of both.

In order to maximize the value of a stock option grant, employees should always try to minimize the resulting tax liabilities. Stock options can be tricky creatures from this perspective since the option grant, exercise, and resulting stock sale can all be taxed differently. Exercising ISOs can even subject employees to the alternative minimum tax (cue shudder). Thus, tax minimization should be a focal point of any long term stock option strategy.

 

2) Exercising Options and Selling Shares Immediately

Rather than exercising and selling immediately for a profit, it’s almost always better to exercise employee stock options and hold the shares for at least a year. By doing so, the difference between the sale price and strike price is taxed as a long term capital gain instead of ordinary income.

Since long term capital gains are taxed at lower rates than ordinary income, this can be a big tax saving technique. Also, keep in mind that incentive stock options must also be held for two years after the grant date to qualify as long term capital gains.

 

3) Forgetting About Them Until It’s Too Late

The very worst case scenario is when employees forget about stock option grants and allow them to expire unused. While not nearly as costly, another common mistake is neglecting options until they approach expiration. Allowing the exercise window to close limits your options, thwarting the benefits of a thoughtful long term plan.

Employees should start thinking about their stock option strategy immediately after they’re granted. Starting early leaves you the most flexibility, and the best opportunity to minimize taxes and maximize their value.

 

4) Neglecting Stock Plan Rules Before Resigning

Most companies force employees to exercise stock options upon termination of employment. Normally they have 90 days to take action, but the window varies from place to place.

This window for stock options will also be different than the windows for severance packages and other benefits, making things a bit confusing. Before tendering resignation, be sure to understand your company’s stock plan and set a strategy accordingly.

 

5) Failing to Account for a Merger or Acquisition

Mergers and acquisitions affect employee stock options in several different ways. Sometimes vesting schedules accelerate, while in others the existing company’s shares will be phased out and replaced with the new company’s.

When going through a merger, employees should keep abreast of how management is handling their stock plan, and adjust accordingly. If necessary, pester HR for up to date information. The only way to maximize stock option value is to concoct a strategy with up to date data.