If you are lucky enough to be granted incentive stock options (“ISOs”) as part of your compensation package, it’s important to understand the timeline of events. The timeline includes when your ISOs are granted, when they vest, when exercised, when the exercised ISO shares are sold, and when your ISO grant expires.
All of these events can impact how and when you may be able to act on your incentive stock options and what these actions mean to you from a tax standpoint, a cash flow standpoint, and ultimately how much money ends up in your pocket.
This article will discuss the general timelines associated with ISOs, the potential tax implications, and help you make the most out of your ISOs with as few surprises as possible.
Incentive Stock Options at Grant
The grant of incentive stock options is a non-taxable event. Simply stated, your company is giving you an award of ISOs that will allow you to purchase shares of company stock at a pre-determined price for a set period of time. When an incentive stock option is granted, you will receive an award agreement that details a few key features of your award.
These key features include:
- Grant date: Generally, the grant date for ISO is the day you are granted the options.
- Vesting Commencement Date: The vesting commencement date is the day on which your ISOs start to vest. Upon vesting, you have the right to exercise your option and purchase the underlying shares.
- Vesting Schedule: There are two vesting schedules for ISO plans: cliff vesting and graded vesting. With cliff vesting, all the option shares become vested at once after the vesting commencement date. The option vest gradually over time with graded vesting according to a pre-determined schedule. The most common type of vesting schedule is graded vesting, which allows employees to accrue progressively more ownership in their options over time.
- The Expiration date: The expiration date is the last day to exercise your ISO options. After this date, the options will no longer be valid, and you will no longer have of the ability to exercise the option and purchase the shares. The expiration date is typically ten years from the grant date for ISO. If you do not exercise your ISOs within this time frame, they will expire, and you will lose all ownership of the shares.
- The Exercise Price of the Option: The exercise price is the price you can purchase shares of the company with your ISO options, typically set at the fair market value of the underlying stock on the date of grant.
- The Number of Options Awarded: The number of shares that you can buy via the option grant award.
Generally speaking, you cannot exercise your ISOs at grant. Instead, you will need to wait until the ISOs vest. An exception to this general rule is if your company allows for an early exercise (this is more commonly seen with pre-IPO companies). An early exercise provision will enable you to exercise your ISOs before they vest. If you elect to early exercise and file an 83(b) election, you can accelerate the taxable event (as it relates to AMT liability) prior to the options being vested, with the idea of later minimizing the overall AMT impact.
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At grant, it’s essential to take note of the key features of your agreement, how and when you can take action, and what other relevant provisions of the grant agreement may be applicable.
Incentive Stock Options at Vest
Assuming you do not have an early exercise provision, the date that your ISOs vest is the first date that you can act on your right to exercise the option. Vesting schedules can vary, so you should know how your ISOs vest over time, and for that, you would typically look to your option agreement provided at the time of your grant.
Using a hypothetical example to illustrate a vesting schedule, let’s assume that you have 10,000 ISOs that have a vesting schedule that looks like this: 25% vest 1 year following the vesting commencement date and then quarterly over the next 12 quarters. This vesting schedule will look like this:
Vesting options, by themselves, do not cause a taxable event to occur, rather it is the act of exercising that creates a reportable tax event. If you choose not to exercise, you ISOs simply remain “vested and unexercised.”
Incentive Stock Options at Exercise
When you exercise your ISOs, you are electing to act on your right to buy shares of company stock at the pre-determined exercise price of the option, regardless of the current stock price. Exercising ISOs is a reportable tax event. It is reportable regardless of whether or not you retain or sell the newly acquired shares. (There are no income tax consequences upon exercise but there may be AMT consequences, depending on how long the shares are held)
You may want to exercise your incentive stock options for many reasons. For example, you may want to exercise and sell your ISOs if the current stock price is considerably higher than the exercise price and you feel as though the stock price has peaked. Alternatively, you may want to exercise and sell ISOs if you have a financial goal you want to fund, such as retirement, a second home, or a college expense.
However, exercising and selling your ISOs is not the only option. You may want to exercise the option and hold shares of company stock because you think the stock price will go higher or you are seeking optimize your tax situation by holding for the preferential long-term capital gain treatment offered by ISOs.
Generally speaking, what you do after exercising your ISOs dictates how you may be taxed. If you exercise your ISO and sell shares before the calendar year-end, you will likely need to report tax as some combination of ordinary income and capital gain/loss. However, any potential AMT liability will go away.
If you exercise and hold your shares past the calendar year-end, you will need to report an adjustment for figuring the alternative minimum tax for the year of exercise. It’s possible, depending on the spread between the exercise price of the ISO and the FMV at exercise, that you may have a considerable AMT due. If this is the case, you should plan for your cash flows to ensure you can cover any tax liability.
While preferential tax rates can be attractive, you should be mindful of the inherent volatility associated with a single stock. If the stock price decreases in value post-exercise, you may wind up with less than had you simply sold on day one and paid a higher tax rate.
Incentive Stock Options When You Sell the Stock
Exercising your ISOs is step 1 of a process that allows you to purchase shares of stock at a price that is lower than the current fair market value of the stock. Exercising ISOs, however, is simply buying shares of stock. The second part of the process, which is not so straightforward, is determining when to sell the newly acquired shares. Selling shares is the step that allows you to capture the profits and redirect the after-tax proceeds into something more meaningful to you.
Selling stock can be difficult for many reasons, and potentially more so if you have a significant part of your net worth tied up in a single stock. Very simply, selling stock is a big decision, which should be taken by considering the various pertinent factors. Because of this, it’s reasonable that you may avoid selling in fear of making a mistake or not knowing where to start.
Other times, selling stock may be inhibited by the fear of missing out if the stock price goes up after you sell. A third reason for not wanting to sell is to avoid paying taxes (even though it’s possible you’re only paying tax because you’ve made a lot of money).
Whatever the reason is, selling can be difficult, but selling is necessary if you seek to transition value from a single stock (potentially risky) to help satisfy another goal (potentially less risky). Ultimately, it’s how you can use the value of your stock to fund whatever financial planning need that is most important to you.
When you do sell, you will want to understand what happens next. First and foremost, you will see the proceeds from the sale hit your account as cash
Next, you will want to plan for taxes. Keep in mind that no taxes are withheld when you exercise ISOs or when you sell ISO shares. So even though you may see the full proceeds of the sale deposited into your investment account, you should likely plan to set some of these proceeds for taxes. To help determine how much you should set aside, you should know if your sale is a qualifying or disqualifying disposition or sale.
A qualifying sale for ISO shares is defined as a sale that meets specific holding period requirements:
- The sale must occur more than two years after the ISO grant date and more than one year after the ISO exercise date.
If your sale is qualifying, you will receive a favorable long-term capital gains rate on the gain between the original exercise price of the ISO and the final sale price. Additionally, with a qualifying sale, you may also get a negative adjustment to your AMT income that allows you to get back previously paid AMT as a tax credit.
A disqualifying sale for ISO shares is defined as a sale that does not meet the requirements of a qualifying sale. In other words, it’s any sale that doesn’t meet both holding period requirements. When you have a disqualifying sale, you’ll likely pay some combination of ordinary income and short-term capital gains tax rate, which is less favorable than the long-term capital gains rate.
ISO holders are responsible for managing their own tax situation, so it’s essential to plan and know what your ISO exercise and sale will look like.
Once the tax is covered, you can plan for what to do next. The after-tax proceeds can be used to fund your goals, objectives, retirement, or whatever is most important to you.
Incentive Stock Options at Expiration
One of the significant benefits of ISOs is that you can choose to exercise your option or choose to wait. A number of factors may impact your timing, including the value of the options, taxes, your personal goals, objectives, or other matters.
However, incentive stock options have a finite lifespan–ISOs eventually expire. The expiration date is typically ten years from the grant date, but it can vary depending on your company’s plan document. It is also important to be aware of what happens to your vested options if you leave your company—often your ISOs will expire after a much shorter period, usually 3 months. Keep in mind that when your ISO shares expire, you will no longer be able to exercise them, and this can be a significant setback for employees who have worked hard to earn them, so it’s essential to understand how expiration can affect your position.
What Now With Incentive Stock Options
ISOs are a powerful form of equity compensation, and they have the potential to create a lot of value if your company performs well. This is why it’s essential to understand their unique tax treatment and the rules surrounding grant, vesting, exercising, sale, and expiration.
You need to know what happens when ISOs are granted and how to make good decisions when you exercise them. You also need to understand the tax and cash flow impact of an exercise and hold, or sale. Your risk tolerance and how much company stock you wish to keep in your portfolio will be an important consideration in guiding this decision.
By understanding these concepts, you can begin to best plan for how your ISOs fit into your overall long-term financial plan.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.