There are two types of employee stock options: incentive stock options and non-qualified stock options. Incentive stock options (abbreviated “ISO’s”) are sometimes called “statutory” or “qualified” options because they come with tax benefits that non-qualified options don’t.
This explainer will guide you through how ISO’s work and their tax benefits. We’ll highlight the differences between ISO’s and non-qualified options along the way.
The Basics - ISO vs. NQSO
Here’s a 20,000 foot overview.
While non-qualified stock options (“NQSOs”) and an ISOs are taxed differently, they have one similarity: you do not owe any income tax when either one is granted. The difference begins when you exercise the options and receive company stock.
When you exercise a NQSO, you pay ordinary income tax on the value of the company stock less the amount you paid to exercise the option. You’ll have to pay income tax and social security and Medicare taxes on that too! Then, when you sell the stock later you pay capital gains taxes on any growth.
The benefit of an ISO is that you don’t pay ordinary income taxes when you exercise the option. Instead you pay long term capital gains taxes when you sell the stock. The trade off is you may also pay Alternatie Minimum Taxes when you exercise.
What is an Incentive Stock Option?
There are a number of rules that determine when a stock option is treated as an incentive stock option for tax purposes. Some your employer must follow and some you must follow. From the perspective of the employee, probably the most important rule is the holding period.
Let’s see how it works.
Holding Period Rule
There are two dates you need to keep track of for the holding period rule: the grant date and the exercise date.
In order for an option to be taxed as an ISO, you must hold onto the stock that you receive upon exercising the option until the later of:
- Two years from the grant date of the option, and
- One year from the date you exercised the option.
In practice this means if you wait for one year after the grant date to exercise the option and then wait at least another year to sell the stock, the stock will receive beneficial ISO tax treatment. Most companies have vesting periods that prevent you from exercising in the first year anyway.
Other Rules To Be Aware Of
In addition to the holding period, there are a few other things you need to keep in mind regarding ISO’s.
First, for an option to be treated as an ISO you have to be employed by the company at all times from the grant date through three months before the exercise date. That means (a) you need to be an employee when you exercise the option and (b) if you leave the company, you may be able to exercise the option for 3 months after you have been terminated. (Check your stock option plan to be sure!).
Second, the ISO is exercisable for no more than 10 years after the grant date.
Third, an ISO isn’t transferable during your life. That means you can’t gift it to a family member while you’re alive. However, you may be able to have it transferred by will after you die if your employee stock option plan allows it.
How ISO's are taxed - if you hold long enough
To see how ISO’s work if you meet the holding period, let’s see an example.
Let’s say you were granted an ISO by your employer on January 1, 2020. The exercise price (a.k.a, strike price or option price) is $10 a share, the option is good for 100 shares, and it vests in one year’s time. You wait and exercise the option on January 1, 2021. At that time the Fair Market Value of the stock is $40. You give your employer $1,000 ($10 per share exercise price x 100 shares) and you receive 100 shares. You eventually sell the stock for $50 a share on January 2, 2022.
You’ve met the holding period rule because you waited one year from the grant date and sold a year after that. So, we can treat this as an ISO. We’ll assume the “other rules” are met.
The value of the stock when it was granted doesn’t matter from a tax perspective. You pay no tax on the grant date and you don’t pay ordinary income when exercising the option. However, you may have to pay Alternative Minimum Tax.
Alternative Minimum Tax
The Alternative Minimum Tax is triggered when you exercise an ISO in one year and and hold the stock into the next year. When that happens you have to add back the “bargain element” of the ISO to your regular taxable income. The “bargain element” is the fair market value of the stock on the day you exercised the option LESS the exercise price you paid. If the total taxable income after the add back is greater than your regular taxable income, you have to pay tax on the greater amount. That is called your Alternative Minimum Tax.
Let’s see how it works.
In our example above, the bargain amount in 2021 was $3,000 ($40 per share fair market value on exercise date less $10 per share exercise price for 100 shares). You exercised the option in 2021 and held the stock into 2022. That means for 2021, you have to add the $3,000 to 2021 your regular taxable income. You pay the greater amount of that or your regular income tax. (This would also be true if you held onto the stock through 2022 and didn’t sell.)
Disqualifying Disposition
In the above example, if you exercised and sold the stock in 2021 (and didn’t hold the stock past the end of 2021) you wouldn’t have to pay the Alternative Minimum Tax. However, the ISO would be taxed as a NQSO (See above). That means you would have to pay ordinary income taxes based on the value of the stock on the exercise date PLUS short term capital gains on the sale.
While that sounds bad, there may be circumstances when that saves you money over the normal ISO treatment.
For example, let’s say you exercise an option in 2021 and would owe $20,000 in AMT if you held onto the stock. If the stock falls in value the next year you might not be able to sell it and cover your tax bill. If you decide to sell it in 2021, it may be worth it to avoid a falling market!
In a falling market careful planning is key if you want to know whether to hold onto the stock or sell early.
Conclusion
I hope you found this summary of Incentive Stock Options useful. Stock options can get complicated. It pays to take the time to run the numbers and consider whether to exercise, hold, or sell.
In future posts I’ll cover strategies for exercising ISO’s and when it makes sense to hold or sell.