Companies have several tools they can deploy in order to retain top talent, and one that is gaining traction is incentive stock options, or ISOs. Much like non-qualified stock options (NSOs), ISOs are a form of equity compensation in private or public companies.
ISOs give employees the chance to buy shares of company stock at a discount, and are typically reserved for executives or key employees. ISOs can be an attractive way to retain valued team members due to the preferential tax treatment they allow. To understand their tax benefits, let’s first review a concept called the Alternative Minimum Tax, or AMT.
Alternative Minimum Tax
Employees utilizing ISOs may find themselves subject to the Alternative Minimum Tax, or AMT. AMT is a measure to ensure that taxpayers receiving certain tax-preferred income – like ISOs or municipal bonds – pay a minimum tax rate.
There is an AMT exemption amount, so lower-income individuals may not be subject to AMT, while higher-earning individuals may be impacted, such as those exercising large lots of ISOs. AMT is taxed at either 26% or 28%, which is often lower than NSOs taxed at ordinary income tax rates. What makes AMT unique is that the amount of taxes paid may be used as a credit in future years. But this is limited to years that no AMT income is generated, and only to the extent that ordinary income exceeds AMT.
What Does it Cost?
Before exercising an option, it’s always good to remember that stock options are the option and not the obligation to purchase a company’s stock. Employees who are given these options do not have to take part in the offering, although many times they may have a financial incentive to do so.
When exercising an option, there are two costs to consider: the cost of exercising the option and the associated tax that comes with it. The cost of the option is equal to the “strike price” of the option multiplied by the number of options exercised. Taxes upon exercise are calculated based on the “bargain element,” or the difference between the strike price and what the shares are valued at on the day of exercise. For ISOs, taxes on the bargain element are then potentially taxed as AMT.
- Cost to Exercise = Cost of Option + Taxes on Exercise*
- Cost of Option = Strike Price * # of Options Exercised
- Taxes on Exercise* = (FMV – Strike Price) * # of Options Exercised
(Taxes on Exercise may be an AMT preference item – as referenced above – or taxed as ordinary income in the event of a disqualifying disposition.)
How Much to Exercise?
The amount you exercise in an ISO purchase may largely be a financial decision. Is the current share price higher than the “strike price” of your option? Do you have the funds necessary to exercise? Will you owe additional taxes?
While some individuals will have saved up the funds required for their ISO exercise, others may require more creative ways of financing. Short-term loans may be available through banks, financial institutions or the employer. Employers may allow for loan provisions within the 401(k), or the client’s custodian might offer lending on other assets via a securities-backed loan.
Others may decide to exercise NSOs in a call-to-cover strategy, allowing the ISOs to maintain preferential capital gains treatment via a qualifying disposition.
Qualifying Dispositions
A qualifying disposition determines which tax rates will be levied on these options. To “qualify” for this preferential tax treatment, an ISO must be held for at least two years from the date it was granted and at least one year from the date it was exercised.
If the stock is eventually sold after a qualifying disposition, you can enjoy the benefits of AMT and long-term capital gains rates, which currently cap at 23.8%. If the stock is sold after a disqualifying event, you risk getting taxed at your highest ordinary income bracket. The “2-1 Rule” for Qualifying Dispositions can therefore be one of the most important things to consider when using this strategy.
ISOs in Action
Let’s look at a hypothetical “real world” example of ISOs: Prakash was granted 1,000 ISOs at $1. The ISOs came with a three-year vesting schedule, prohibiting Prakash’s ability to fully exercise the ISOs until his third work anniversary. Should he decide not to utilize the ISOs, they also had a seven-year expiration date, at which point his ISOs would no longer be usable.
On Prakash’s fifth work anniversary, his company stock was valued at $6 per share. Believing that the company stock would keep increasing, Prakash exercised all 1,000 options at the original cost of $1 per share. This would have resulted in an AMT adjustment of $5,000 – take the current price ($6) minus the original price ($1) and multiply by the number of options (1,000).
But because Prakash’s household income was below the AMT exemption for that year, he did not owe any additional taxes for exercising the ISOs. Had his income been above the annual exemption or if his AMT adjustment was substantially more, this could have added to his overall tax bill.
Prakash is aware of the tax benefits in waiting for a qualifying disposition of his ISOs, and thus decides to wait at least one year before selling his shares. His patience is rewarded, as just a few months later, his company announces its intent to go public.
When the company holds its IPO the following year, Prakash is pleased to discover his stock is now worth $13.50 per share. Wanting to further his financial goals and pay down his wife’s student loans while also still taking advantage of the company’s future growth potential, Prakash decides to sell half of his equity position.
Prakash’s current equity position is $13,500 ($13.50 per share x 1,000 shares), while his realized equity position is $6,750 ($13.50 per share x 500 shares). His capital gain income upon sale equals $3,750 – take the current share price ($13.50) minus the share price when Prakash exercised his options ($6) and multiply by the number of shares sold (500).
Putting it All Together
Prakash has both NSOs and ISOs. He has accumulated 1,000 of each over his career, all of which were granted at $1 per share. Prakash would like to exercise his options before they expire, but unfortunately does not have the cash available.
His financial planner suggests a call-to-cover strategy. In doing so, Prakash first exercises and subsequently sells half of his NSOs, valued at $6 per share.
- Cost of exercising: $1 per option x 500 options = $500
- Taxes on exercising: ($6 – $1) x 500 options = $2,500 ordinary income, which at a 12% effective rate comes to $300
- Sale proceeds: ($6 – 1) x 500 options = $2,500
So if we take the full sales proceeds ($2,500) and subtract the cost of exercising ($500) and the additional taxes ($300), Prakash earns $1,700 in net sale proceeds. Prakash then uses his net sale proceeds to exercise his remaining 500 NSOs and 1,000 ISOs.
- Cost of exercising NSOs: $1 per option x 500 NSOs = $500
- Taxes on exercising: ($6 – $1) x 500 NSOs = $2,500 ordinary income, which at a 12% effective rate comes to $300
- Cost of exercising ISOs: $1 per option x 1,000 ISOs = $1,000
- Prakash’s total out of pocket: $1,700 – $500 – $300 – $1,000 = a net loss of $100
By utilizing a call-to-cover strategy, Prakash preserves the majority of his options with very little cash outlay. He maintains the tax benefits of the ISOs by not selling them before the 2-1 qualifying disposition clock, and is able to hold onto his equity should his company experience substantial growth in the future.
This example does not reflect sales charges or other expenses that may be required for some investments. Rates of return will vary over time, particularly for long term investments.
This blog is not intended to provide specific legal, tax, or other professional advice. For a comprehensive review of your personal situation, always consult with a tax or legal advisor.