The Basics of Incentive Stock Options

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Key Points:

  • ISOs allow you to buy shares of stock at a predetermined price (the exercise price) for a set period, regardless of the current market price.
  • The grant date for your ISO is the date you are awarded the options. The value of the shares on the grant date helps determine your exercise price.
  • The vesting date is the first date your options become available. The number of options that vest on this date and subsequent dates are subject to the rules of your ISO plan document.
  • The expiration date is the final day you can exercise your right to buy your shares at the exercise price.
  • If you exercise your options, you will trigger a taxable event. The actual tax outcome is subject to when you exercise, how long you hold the shares, and how far past the original grant date you may be.

There are two types of employee stock options: incentive stock options, or ISOs, and non-qualified stock options, or NQSOs.

Generally speaking, incentive stock options are the more complicated of the two. These complexities may include holding period requirements, potentially preferential tax treatment, and the alternative minimum tax.

You might find yourself with many questions about these important but often confusing parts of your incentive stock options. But before you dig too far into the complex aspects of your options, you’ll want to get a firm grasp of the fundamentals.

You need to know what you have, when you can do something about it, and when your option goes away. Having this information provides you with what you need to draft a strategy to incorporate your incentive stock options into your financial plan.

What is an Incentive Stock Option?

An incentive stock option is a form of compensation offered to an employee, often as part of a larger compensation package. Incentive stock options can only be granted to active employees and can only be granted up to specific limits.

ISOs allow you to buy shares of stock at a predetermined price (the exercise price) for a set period, regardless of the current market price of the stock. If the current stock price is higher than your exercise price, your stock options have value. If the current market price is below the exercise price, your stock options are currently underwater.

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Incentive stock options may allow you to obtain preferential tax treatment as compared to non-qualified stock options. Paying less in tax, all else being equal, may make them the more valuable type of option.

Key Dates for Incentive Stock Options

There are several key dates that you should be aware of with your incentive stock options. They are important because they inform you of when you are awarded your incentive stock options, when you can exercise and take ownership of stock, and when you no longer have the right to the option.

These dates are known as the grant date, the vesting date, and the expiration date.

The grant date for your incentive stock options is the date you are given the shares. The grant date is also the date the shares are typically valued and the value often determines your exercise price. The exercise price is the price you pay to buy shares of stock via your option. However, the grant date is not necessarily the time when you can exercise your option to purchase the shares.

That date is often the vesting date (unless you have an early exercise provision). Before the vesting date, you simply have a future promise. Once you reach the vesting date, you can act upon your option to exercise.

When you exercise, you may turn the value of the option into a value that you can use. Said another way, at exercise, you turn the value of your options into actual cash that can be used for whatever you want (assuming your sell the shares, too).  But this may not be the best option if you are looking to obtain long-term capital gains treatment.

The vesting date is the first date your options become available. The number of options that vest on this date and subsequent dates is subject to the rules of your incentive stock option plan document.

Some plans allow for a fixed date when all your incentive stock options vest and others allow a certain percentage of shares to be vested over a rolling period.

The Expiration Date of Incentive Stock Options

The final key date for your incentive stock options is the expiration date.

The expiration date is the final day that you can exercise your right to buy your shares at the exercise price. Should this date pass and your options go unexercised, your options simply go away — and that could mean a big missed opportunity.

For example, let us assume that you had 1,000 incentive stock options with an exercise price of $2 per share and the stock has a current market value of $50 per share, that’s $48,000 of potential value.  Let’s also assume these options expire at the end of the day today. If you exercise today, you can buy shares and “capture” the $48,000 of immediate benefit (you may want to consider if you’re going to exercise and hold your shares or exercise and sell them).

Fail to exercise by the end of the day, however, and your option to buy the stock at $2 per share expires. Overnight, you forfeited the right to $48,000.

This is why it’s critical to have a plan in place so you can get clarity and understand what you’re supposed to do. Otherwise, you may not take any action at all because you don’t know what to do or feel overwhelmed by the process.

As we can see, failing to act can lead to a lost opportunity if you don’t act before your options expire.

What Happens When You Exercise Your Incentive Stock Options

When you exercise your incentive stock options, you’ll trigger several things that you’ll want to address.

First, you need to pay for the shares you buy. The cost of the shares you buy is equal to the number of options exercised, multiplied by the exercise price of the option.

Here’s an example:

  • Number of Options Exercised: 1,000
  • Exercise Price: $2.00 per share
  • Current Share Price: $50.00

The cost of this exercise is equal to 1,000 x $2.00, or $2,000. In other words, you need $2,000 in cash to cover the cost of buying the shares.

You could pay that from your cash flow or from your savings. You may also be able to pay for the $2,000 expense by selling off some shares immediately after you exercise them, in a sell-to-cover or cashless transaction).

In addition to the cost of exercising, exercising your incentive stock options creates a reportable event for tax purposes. The bargain element, which is the spread between the exercise price and the fair market value at exercise, multiplied by the number of options exercised, may be included in your tax return for the calendar year of the exercise.

In our example, the bargain element equals the number of shares exercised multiplied by the (fair market value at exercise less the exercise price). That’s 1,000 x ($50-$2), or $48,000.

Assuming that you exercise and hold the shares past the calendar year-end, the bargain element will be used on your tax return as either a tax preference item for calculating AMT.  If you exercise and sell your incentive stock options immediately, the bargain element is generally taxed as ordinary earned income (not subject to Social Security and Medicare Tax). The actual tax outcome is subject to when you exercise, how long you hold the shares, and how far past the original grant date you may be.

Incentive Stock Options and the AMT

When you exercise incentive stock options, you could also wind up owing alternative minimum tax, or  AMT.

AMT is an annual tax calculation run concurrently with your regular tax. The bargain element of exercised incentive stock options is included as income when calculating if you owe AMT. In our example, your bargain element is equal to $48,000.  If we assume a flat AMT tax rate of 28%, we can calculate that you will owe $13,440 in AMT (the actual calculations for AMT of more complicated than this example, and it often makes sense to consult with a professional)

To summarize our examples, if you exercised and held 1,000 shares worth $50,000 (that you paid $2,000 for), you’d create an AMT bill of $13,440. AMT would be paid when you file your tax return in the year following the year of exercise.

A Qualifying Disposition of Incentive Stock Options

Even the basics of incentive stock options can leave one’s head spinning. So why go through all this mess?

The usual answer is that making the right decisions could make thousands of dollars worth of difference on your tax bill. If there’s a way to pay less tax and end up with more money, it’s worth exploring.

With incentive stock options, the gain from the exercise price to the final sales price may be eligible for long-term capital gains treatment. To achieve this preferential tax treatment, you need to meet the standard for a qualifying disposition.  That is:

  • The final sales price is at least 2 years from the grant date and
  • The final sales price is at least 1 year from the exercise date

To illustrate the potential value of a qualifying disposition using numbers, we can continue our example and assume a final sales price of $50 per share, a 33% ordinary income tax rate, and a 15% long-term capital gains tax rate.

We see the following:

Ordinary Income Capital Gains
Exercise Price $2.00 $2.00
FMV at Exercise $50.00 $50.00
Total Proceeds (1,000 shares) $50,000 $50,000
Total Gain (1,000 shares) $48,000 $48,000
Taxed as ordinary income (33%) $16,000 $0.00
Taxed as capital gains (15%) $0.00 $7,200
Net proceeds $34,000 $42,800

 

The net proceeds from this hypothetical transaction favor capital gains tax, as illustrated through a qualified disposition.

(To be fair, a full analysis should include AMT paid as a result of the original exercise as well as a potential AMT credit. For simplicity, we have left them out.)

The AMT Credit for Incentive Stock Options

In an effort to obtain a qualifying disposition and to pay long-term capital gains, you will need to exercise and hold ISO past the calendar year-end and may incur AMT.  By doing so, you may feel as though you pay tax twice.

You first paid tax in the calendar year you exercised and held your ISO due to the AMT.  You pay tax a second time as a long-term capital gain when the final shares were sold. Are you getting taxed twice?

Not with the AMT credit.  The AMT credit allows you to go back and get some (and possibly all) of the AMT paid due to exercise in the form of a tax credit.

When you sell shares from your previously exercised ISOs, you may receive an offsetting adjustment for had caused you to pay AMT in the first place. This offset to the tax calculation may allow you to get AMT back in the form of a tax credit.

The exact details of AMT are complicated and require a personalized tax projection. How much and how quickly you could receive a will be determined by those tax projections.

The Basics of Incentive Stock Options Aren’t So Basic

Incentive stock options may be considered fundamental if you exercise and sell them immediately. But this may not be in your best interest because you may not be taking advantage of potentially preferential tax treatment, leaving you to pay more tax than you otherwise may need to if you are meeting the holding requirements.

Beyond this simple exercise and sell strategy, stock options are anything but basic. Consequently, it makes sense to consult with an expert who has experience working with ISOs and the potential opportunities and pitfalls for your specific case. It’s worth getting a professional perspective so you can be sure you’re crossing your T’s and dotting your I’s in the best possible way.

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. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. 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.

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Hi, I'm Daniel Zajac, CFP®, EA

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I write about equity compensation and employee stock options in a way that is easy to understand.

5 Comments

  1. Richard Ruttenberg

    Hi. I’m not clear about your statement that:
    “If you follow the transaction above, you will notice that you have paid tax twice on the spread between the exercise price and the fair market value at exercise.

    You first paid in the calendar year you exercise your options as AMT. You paid a second time as long-term capital gain when the final shares were sold. Are you getting taxed twice?

    Not with the AMT credit, which allows you to go back and get some (and possibly all) of the AMT paid due to exercise in the form of a tax credit.”

    Does the above mean that you only get an AMT credit if there’s a LONG TERM gain? What about if it’s a SHORT TERM gain?

    Thanks.

    Reply
    • Daniel Zajac, CFP®, AIF®, CLU®

      Hi Richard – If you have a short-term gain, it’s possible that you did not get a qualified sale on the ISO itself. Generally speaking, if this exercise and sale of ISO that creates a short-term gain occurred in the same calendar year, no adjustment would likely need to be made for AMT in the first place, so there would not be an AMT credit to begin with (in a silo, not looking at any previous activity)

      Reply
      • So if you exercise and sell the iso in the same calendar year, does the excess of fair market value over exercise price still go into the AMT calculation, or only in the regular tax computation?

        Thanks, Daniel. So if you exercise and sell the iso in the same calendar year, does the excess of fair market value over exercise price still go into the EMT calculation, or only in the regular tax computation?

        Reply
        • Daniel Zajac, CFP®, AIF®, CLU®

          If you exercise and sell ISO in the same year calendar year, no adjustment will be made for AMT reporting. Assuming the final sales price is greater than the strike price of the option itself, some or all of the gain will be taxed at ordinary income rates. Its possible some portion of the proceeds could be taxed at capital gains rates too (for example, if the final sales price is greater than the fair market value at exercise)

          Reply
      • Richard

        Thanks, Daniel. So if you exercise and sell the iso in the same calendar year, does the excess of fair market value over exercise price still go into the EMT calculation, or only in the regular tax computation?

        Reply

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