Incentive stock options are a form of equity compensation granted to employees of public and private companies. Unlike non-qualified stock options, restricted stock units (RSUs), and employee stock purchase plans (ESPP), incentive stock options carry a few more complexities. However, in exchange for these complexities is the ability to participate in the future growth of your company, generate wealth, and receive preferential tax treatment. To maximize this benefit, it’s important to understand the taxes on incentive stock options.
With any form of equity compensation, especially incentive stock options, it’s crucial to develop a plan of action to maximize your dollars and minimize the impact of taxes. However, it’s also important to note that taxes shouldn’t be the primary decision-maker in your equity compensation planning. While taxes are significant, you want to blend planning around your personal finances and your goals.
The first step in figuring the taxation of your ISOs is to determine if the sale of stock is a qualifying or disqualifying disposition. We will discuss disqualifying dispositions later in this post. Incentive stock options (ISOs) typically allow employees to avoid paying taxes until the shares are ultimately sold. This means that ISOs offer the opportunity for preferential tax treatment as long as special rules are met. For example, if the rules are met, a qualifying disposition allows for a more favorable long-term capital gains rate. Here are the requirements:
Let’s look at a quick example of this in real life:
To determine if this is a qualifying disposition, we first need to ask if both rules above are met.
Since both rules have been met, this is a qualifying disposition. This means the profit between the final sale price and the exercise price can enjoy long-term capital gains tax treatment.
To determine the long-term capital gains on this transaction, you calculate that difference, then multiple the number of shares.
(Final sale $70/share – Exercise or strike price $10/share) X Number of options 1,000 = Long term tax treatment $60,000
Depending on your tax bracket, long-term rates could be either 0%, 15%, or 20%. In a qualifying disposition, you won’t owe ordinary income taxes. However, in the year of exercise, you could be subject to AMT.
If you exercise your ISOs and continue to hold the shares, additional complexities can come into play. This can trigger the alternative minimum tax. We aren’t going to get into the details of AMT in this post, but know that it’s an alternative tax calculation that you need to be aware of when you exercise ISOs.
You also need to be aware of the bargain element, which is a preference item for AMT. This bargain element is the difference between the stock’s market value at exercise and the exercise price multiplied by the number of shares. Using the same numbers in the example above, let’s calculate the bargain element.
(Market value of shares at exercise $40/share – Exercise or strike price $10/share) X Number of options 1,000 = Bargain element $30,000
The bargain element is added to your income in the year of exercise to calculate if you owe AMT. The issue is that you may owe AMT before you sell the stock.
At first glance, this could seem like double taxation since you could pay AMT in the year of exercise and capital gains tax when you eventually sell the shares. However, when the shares are finally sold, you may receive an AMT credit to recoup some or all of the tax previously paid as AMT.
What if you don’t meet the rules above for preferential tax treatment? This is a disqualifying disposition. The bargain element is taxed at ordinary income and reported on your W2 as wages in a disqualifying disposition. Remember, the bargain element is the difference between the market price at exercise and exercise price. The profit is subject to short or long-term capital gains depending on when the final sale occurs.
If shares are sold less than a year after the exercise: The difference between the sale price and the market value at exercise is subject to short-term capital gain rates.
If shares are sold more than a year from the exercise date but less than two years from the grant date: The difference between the sale price and market value at exercise is subject to long-term capital gain rates.
With incentive stock options or any form of equity compensation, it’s important to plan for the impact of taxes proactively. Taxes shouldn’t be the ultimate decision, but they can help you lay the best course of action when exercising your options and eventually selling shares. If you find yourself overwhelmed with your equity compensation or need guidance on creating an action plan, we are here to help. Getting a review of your finances and learning how to navigate the complexities can go a long way in keeping more money in your pocket.