If you've been offered stock options as part of your compensation package, you probably have a lot of questions about if, when and how to exercise them. Stock options can be a powerful investment tool because they allow you to purchase stock in your company at a discounted rate. However, they also come with risk and potentially significant tax consequences.

It’s important to remember that not all stock options are created equal, so you need to know which kind of options you have: non-qualified stock options (NSOs), or incentive stock options (ISOs), which we’ll discuss here. Let’s dig in.

What Are ISOs?

Incentive stock options—also known as qualified stock options (QSOs)—are typically given to highly valued employees as part of their compensation package. A company can only offer ISOs to its employees, and there are limits to how many can be offered.

If your company grants you stock options, it simply means they are giving you the opportunity to buy shares of stock in the company at a specific price (the exercise price) during a specific window of time. To obtain shares of stock under a stock option, the employee must still purchase the stock, which is what differentiates ISOs and NSOs from restricted stock units (RSUs).

As your ISOs vest (become available), you can purchase (exercise) a certain number of shares at the exercise price. Ideally, you’ll wait to exercise your options until the market price of the stock exceeds the exercise price. However, it’s important that you don’t wait too long, as stock options have an expiration date. If you don’t exercise your options before they expire, you lose the benefit of the exercise price, potentially leaving money on the table.

What Are the Benefits of ISOs?

Like NSOs, ISOs provide you with an opportunity to purchase shares of stock at a reduced price. Let’s say your company gives you the option to purchase 2,000 shares of stock at an exercise price of $10 per share, but the market value of those shares is $50. That means you can buy $100,000 worth of stock for only $20,000.

However, unlike NSOs or even RSUs, the main benefit of ISOs is the way they’re taxed. NSOs are considered wages, so income tax and FICA taxes are withheld when you exercise your options. That’s not the case with ISOs. Additionally, ISOs have the potential to yield preferential tax treatment. If a certain set of criteria are met (detailed below), ISOs are taxed at lower rates than ordinary income, so when you eventually sell your stock, you’ll end up with even more money in your pocket.

In other words—the key benefits of ISOs is the ability to buy shares of your company’s stock at a discount and the potential for preferential tax treatment over other types of employee stock options.

How Are ISOs Taxed?

ISOs are reported for tax purposes at two different times, when exercised and when sold. How they are taxed when they are sold depends on whether the sale meets the criteria for a qualifying disposition or is considered disqualified.

The first reportable event with ISOs occurs when you exercise your options. ISOs are counted as income when exercised solely for calculating the Alternative Minimum Tax (AMT). It should also be noted that the sale of stock acquired through ISOs also need to be reported for AMT purposes. AMT calculations can get complicated very quickly—so if you are exercising ISOs, speak with your tax advisor first to help you understand the tax implications.

For now, it’s important to understand that when you exercise ISOs, the difference between the exercise price and the fair market value (FMV) on the day you exercise the options will count as income for calculating AMT.

How you are taxed on your gains at sale depends on how long you hold on to your shares. The name of the game is waiting, and how long you wait to sell your shares will determine if you trigger a qualifying or disqualifying disposition.

Tax Treatment of a Qualifying Disposition

The preferential tax treatment that makes ISOs so valuable comes from triggering what’s called a qualifying disposition. This happens when you wait to sell shares acquired at least one year after you exercised your ISOs and at least two years after they were granted.

If a qualifying disposition is triggered, then any profits you make from the sale of your stock are taxed at long-term capital gains rates. And since long-term capital gains rates are lower than income tax rates, this is where you can realize the benefits of ISOs.

To illustrate the benefits and the tax treatment of ISOs, let’s assume you are in the 24% tax bracket and exercised the following ISO:

  • Grant Date: January 1, 2018
  • Exercise Price: $20/share for 1,000 shares
  • Exercise Date: March 1, 2020
  • FMV on Exercise Date: $100

While there is no reliable way to predict short-term stock prices—for purposes of this example only, let’s assume that we sell the shares on April 1, 2021 when the FMV of the stock is $120.

In this example, we’ve met the requirements for a qualifying disposition because the sale date was more than two years from when the options were granted and more than one year from when they were exercised. Since this sale qualifies, the gain from your sale of stock will be taxed at the long-term capital gains rate of 15% (based on your income).

Figure 1. Tax Impact of ISOs—Qualifying Disposition
Total Invested (exercise price) $20,000
Federal Income Taxes Due the Year You Exercise $0
Sale Price of Stock $120,000
Cost Basis ($20,000)
Realized Profit $100,000
Long-Term Capital Gains Rate + Net Investment Income Tax (NIIT) 18.8%
Capital Gains Taxes $3,760
Net Profit from ISO $96,240
Note: In this example, the individual is subject to the NIIT because their adjusted gross income (AGI) is above $250,000. The Net Investment Income Tax is an additional 3.8% on top of the 15% long-term capital gains rate. This example does not account for any AMT owed.

Tax Treatment of a Disqualifying Disposition

If you fail to fulfill either of the waiting period requirements for a qualified disposition, then you have a disqualifying disposition and you lose the tax advantage of long-term capital gains rates.

To compare the impact of a disqualifying disposition, let's use a similar fact pattern to the one above:

  • 24% income tax bracket
  • Grant Date: January 1, 2018
  • Exercise Price: $20/share for 1,000 shares
  • Exercise Date: September 1, 2019
  • FMV on Exercise Date: $100
  • Final Sale Date: July 1, 2020
  • FMV when sold: $120

Note that both the exercise date and the final sale date are different than those used to illustrate a qualifying disposition. In this example, we meet the first test for a qualifying disposition because the final sale date was more than two years from the grant date. However, since we didn’t hold the stock for at least one year after the exercise date, this is a disqualifying disposition.

When a disqualifying disposition is triggered, then the bargain element (difference between FMV on exercise date and exercise price) is taxed as regular income, and the difference between the FMV on the exercise date and the sale date is taxed as capital gain. In our example, the bargain element of $80,000 is taxed at regular income tax rates, or 24%.

As for the capital gain, the rate you pay will depend on whether it is considered a long-term capital gain or a short-term capital gain. If held for at least a year, we meet the requirements for the more favorable long-term capital gains rates. If less than a year passed before the sale, then they are considered short-term capital gains and taxed as ordinary income. In our example, we held the shares for 10 months, so they are taxed as short-term capital gains.

Figure 2. Tax Impact of ISOs—Disqualifying Disposition
Total Invested (exercise price) $20,000
Federal Income Taxes Due the Year You Exercise $0
Sale Price of Stock $120,000
Cost Basis ($20,000)
Bargain element taxed as income $80,000
Income Tax (24%) ($19,200)
Short-Term Capital Gain taxed as Income $20,000
Income Tax (at 24%) + NIIT (3.8%) ($5,560)
Net Profit from ISO $75,240
Note: In this example, the individual is subject to the additional 3.8% NIIT because their AGI is above $250,000. The Net Investment Income Tax is added on top of their regular income rate. This example does not account for any AMT owed.

What Are the Risks Associated With ISOs?

The biggest risk with ISOs is time—which also happens to be the greatest benefit. Bear with us.

There are a lot of unknowns when it comes to stocks. Share prices go up and down all the time, so the longer you hold onto any amount of stock, the more you risk the share prices dropping. In our example, you exercised your ISOs at $20 per share. The hope is that when you decide to sell your shares, the fair market value of those shares has significantly increased.

However, it’s also possible that the value drops.

Further, since ISOs do come with such potentially lucrative benefits, it’s possible for employees to stock up (no pun intended!) on company shares. There are additional risks involved with having such a concentrated stock position, so while it might seem like a good idea to buy up all your options and invest heavily in your company, you’re putting your future at risk should anything bad happen to the value of your stock.

What Should I Do With My ISOs?

That’s a question that only you can answer. A strategic approach that considers factors like your cash flow, tax implications and overall portfolio diversification will give you the best chance of seeing the benefit of ISOs.

There’s a lot to consider when it comes to ISOs. They can get pretty complicated pretty quickly, so it’s a good idea to consult your financial advisor to learn more about how your specific situation impacts how your ISOs are taxed. Your advisor can help you develop a strategy for how and when you want to exercise your options.

 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss.

Jim Wiley

Jim Wiley

Senior Vice President, Financial Advisor

CSA®, AIF®, Series 65 Advisory Registration Jim has more than 35 years of experience in the financial services industry, including years spent with Morgan Stanley. Throughout his career Jim has helped clients with life planning, coaching them on how to help achieve their vision by leveraging their financial resources and focusing on work-life balance. This led him to form Live Your Vision, LLC in 2009 and enter into a partnership with Wealth Enhancement Group in 2019. Jim is...Read More