Employees fortunate enough to receive incentive stock options (ISOs) from their employers have an excellent opportunity to enhance their financial position. However, managing stock options for maximum benefit can be complicated and fraught with hazards that could turn a financial reward into a bad dream. It’s essential to have a clear understanding of incentive stock options, how they work, and the calculations that go into making optimum decisions for how to manage them.
While managing incentive stock options should be based on an individual’s financial, tax, and employment circumstances, Dechtman Wealth Management offers this guide as a foundation for a better understanding of how they work and what you need to consider before making any decisions.
What are Incentive Stock Options?
Incentive stock options, or ISOs, are a form of performance-based compensation granted primarily to key employees, giving them the option to purchase a certain quantity of a company’s shares at a discounted price. Recipients of qualified ISOs generally receive favorable tax treatment upon selling their shares, with profits taxed as capital gains rather than ordinary income.
The awarding of ISOs by a company is intended to motivate and retain key employees who must hold on to them for a certain period of time before capitalizing on their benefits. The more the company’s share price increases, the greater the financial reward, which encourages higher productivity from key employees who benefit directly from the company’s success.
Key Characteristics of ISOs
Number of shares: The number of shares associated with the ISO an employee is offered.
Grant date: The date on which the employee receives the ISO.
Expiration date: The date on which the ISO will expire and is no longer available for purchase.
Exercise price: The price at which an employee may purchase the shares in the future. ISO share prices are generally based on the fair market value at the time of issue.
Exercise method: Payment methods available to purchase the shares, typically with cash and sometimes as a stock swap.
Vesting schedule: The timeline in which ISOs become available to purchase. Typical vesting schedules allow for incremental vesting after an employee has been with the company for at least a year. Additional shares become available monthly, quarterly, or annually.
One-year cliff: Refers to the requirement that an employee remains with the company for a year or forfeit their right to purchase shares.
How Incentive Stock Options Work
The day an employee receives an ISO is referred to as the grant date, from which point it is subject to a vesting schedule outlining the number of months or years they must be held before they can be exercised. When the ISO vests, the employee is able to, though not required, purchase a certain number of company shares at the exercise price, also referred to as the strike price, indicated on the ISO.
ISO recipients can choose when they want to exercise their options anytime up until the expiration date listed on the ISO, typically a ten-year time frame.
How to Exercise Your ISOs
When your ISO is ready to be exercised, you have several options for acquiring your shares.
- You can purchase the shares with cash—a straightforward exchange of a cash outlay to take ownership of shares.
- You can opt for a stock swap if your employer allows it. You swap shares you already own to acquire more shares. For example, you own 500 shares currently trading at $30 in the market. Your ISO entitles you to purchase 1,000 shares at $15 per share. You could swap your 500 shares valued at $15,000 for the 1,000 shares costing the same amount ($15 x 1,000), but you end up with 500 more shares. There would be no tax consequence in this example because there is no profit.
- You can do a cashless exercise using borrowed funds. While it may keep more cash in your pocket, it could disqualify you from favorable tax treatment.
- You can exercise your ISOs with cash and hold on to the shares.
- You can hold on to your unexercised ISOs and exercise them later.
How to determine which option is best is based on a number of factors, including your financial and tax circumstances, among other considerations.
When to Exercise Your ISOs
Two critical decisions need to be made: when to exercise your ISOs and when to sell your stock. Generally, you would consider exercising your ISOs when the current market price of your company’s shares is higher than the strike price of your ISOs, allowing you to then sell your shares at a profit. You will not want to exercise your ISOs if the strike price is higher than the current market price.
If your company is doing well and its outlook is good, you may want to consider holding your ISOs. As your company’s share price increases, the value of your ISOs increases. However, should the value of your ISOs ever reach a point when it represents more than 25 percent of your net worth, you may want to consider exercising your options and selling a portion of your shares to reduce your concentration risk.
The other consideration for when to exercise and sell is determining how the stock proceeds fit into your overall plan and how they might help you achieve any specific goals. That can bring some clarity to deciding how much stock to sell and when to sell it.
In addition, you need to understand the tax implications of transactions involving your ISOs. Generally, ISOs have tax advantages, but they come with holding requirements attached. Understanding the holding requirements is crucial to maximizing your ISO benefits.
Taxation on ISOs
You don’t pay taxes on ISOs when they are granted, vested, or exercised. You pay taxes when the shares are sold. If you meet specific holding requirements, profits from the stock sale are taxed at a more favorable capital gains rate.
Generally, when ISOs are issued or exercised, they do not need to be reported as ordinary income. They only need to be reported as income when you sell the stock. The tax rate you pay depends on the dates you exercise the options and when you sell the stock.
Qualifying and Disqualifying Disposition
If you wait for more than a year after exercising your ISOs and buying shares and two years after the grant date, you will meet the requirements for a “qualifying disposition” and preferential capital gains tax treatment on the profits. The capital gains tax rates for 2022 are 20% maximum (23.8% including net-investment surtax), 20%, 15%, 10%, and zero percent depending on your federal income tax bracket.
However, if you sell your shares two years or less from the grant date, or less than one year from the exercise date, the transaction is a “disqualifying disposition,” requiring you to report the ISOs as compensation on Form W-2. Instead of a capital gains tax rate, your reported ISO compensation will be taxed at your ordinary-income tax rate, a maximum of 37% in 2022.
Alternative Minimum Tax
While you aren’t required to report your ISO grants as income on your W-2, you may be required to report the bargain element for the alternative minimum tax (AMT) calculation. The bargain element is the difference between the exercise price of your ISO and the fair market value of the shares on the day you exercise them. If it triggers the AMT, you could be required to pay the tax even before you sell the stock. It could force you to sell shares when you don’t want to cover the tax. If you sell the stock in that same year, you won’t be subject to AMT.
- If you meet all the one- and two-year holding requirements, ISO grants are not reportable as income—not in the year you receive them, not when they are exercised, and not when shares are sold. The amount you receive from the stock sale above your exercise price is reported on Schedule D as long-term gains.
- If you exercise your ISOs and don’t sell the shares that same year, you are required to report the bargain element as income on AMT Form 6251. If you end up selling your shares that same year, you would not need to report AMT income, but you would report the sale proceeds as ordinary income because it is a disqualifying disposition.
- If you exercise your ISOs and sell them within one year, it is a disqualifying disposition reportable as ordinary income on your W-2. The amount reported is the lesser of the bargain element and the value of the shares when they were sold.
- If you exercise your ISOs and wait one year but sell them within two years of the grant, it is a disqualifying sale. The reporting for this transaction is very messy, requiring that you report ordinary income on the W-2, a long-term gain on Schedule D, and adjustments on AMT Form 6251.
- If you exercise your ISOs and wait one year from the date of exercise and two years from the grant date to sell the shares, you report the profit from the sale on Schedule D with an adjustment to your AMT.
- Clearly, the tax implications of the various types of transactions can be complex and confusing. At a minimum, you should utilize higher-end tax reporting software. But it’s highly recommended that you consult with a tax professional.
Incentive Stock Options vs. Nonqualified Stock Options
Any discussion of tax advantages is moot if you hold nonqualified stock options (NQSO) instead of incentive stock options. NQSOs are another form of extra compensation granted to employees, but they do not receive capital gains tax treatment upon selling shares. Instead, the difference between the strike or exercise price and its fair market value on the date its exercised is reported as compensation on the employee’s W-2 and taxed as ordinary income.
Things to Keep in Mind
In addition to complications around when to exercise your ISOs and the tax implications of transactions, there are several other factors or risks that need to be considered:
Holding period risk: While it may make sense to delay exercising your ISOs to meet the “qualifying disposition” requirement, there is a risk that the share price could decline while you’re waiting, reducing or even negating the value of your ISO.
Concentration risk: If you accumulate enough ISOs to the extent that their value represents a large portion of your net worth, you could be exposed to more risk than you want. As part of an overall asset allocation investment plan, you should seek to diversify your investments to reduce portfolio risk.
No tax withholding: There is no tax withholding with ISOs—when they are granted, exercised, or sold. It is your responsibility to consider the tax liability of selling your shares and have the funds available.
Leaving your employer: It’s important to understand your rights if you leave your employer before you exercise your ISOs. If your ISOs are vested, you have up to 90 days to exercise them to maintain preferential tax treatment. If you don’t meet that timeframe, your ISOs will be converted to NQSOs.
$100,000 ISO Cap: Employers are limited in the dollar amount of ISOs they can issue to employees. If the fair market value of granted ISOs exceeds $100,000 in a calendar year, the ISOs above that limit are treated as NQSOs.
Getting Help with Your ISOs
Your company’s human resources department can provide you with educational materials on managing your ISOs. But there is a significant difference between understanding how your ISOs work and how they work in your specific circumstances. Maximizing the benefits of your ISOs means taking on very complex tax issues, which can detract from determining how to best structure them to advance your personal financial goals. The wealth advisors at Dechtman Wealth Management can help you navigate the complexities of ISOs while maximizing their value in your overall financial plan.
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