Incentive Stock Option Advantages
Incentive Stock Options (ISOs) are a wonderful compensation device that are very complicated. Do you ignore them because you don’t comprehend how they work? Perhaps at some point you’ve made a costly mistake with ISOs and when looking back on your experience, you say, “Oh, I shouldn’t have done that, why didn’t I take the time to understand?”
ISOs are an incredible way to grow your wealth and create financial freedom and independence. Companies award ISOs to employees for a variety of reasons, including but not limited to, rewarding business growth, retaining employees, and attracting new talent.
ISOs have many advantages and it’s best to fully understand them, so that you can benefit from them and grow your wealth substantially.
How ISOs Work
An ISO is a stock option that gives you the right to purchase shares at a predetermined price. Only employees of the company can receive ISOs.
With ISOs, the company gives you an option grant, a document that tells you the number of shares that you can purchase. Additionally, there is a vesting schedule which tells you the dates the options can be sold. The ISO grant will also include the exercise price, and it is usually based on the stock price on the day the company grants the options. The exercise price determines how much you pay for each ISO.
ISO Exercise Process
The process to exercise an ISO is straightforward. If the stock price has risen since the option grant, you will have the benefit of stock price appreciation. You can exercise your stock option in one of several ways, depending on your financial goals.
Typically, you can exercise your options once they have vested. Some plans offer an early exercise option that allows you to exercise shares before vesting. Let’s say you have 4,000 options at an exercise price of $30 per share and 1,000 options have vested since you received your option grant. When you exercise an option, you can do it in a few different ways.
First, you can pay cash to purchase the shares. You could purchase those shares for $30,000 (1,000 vested options x $30). By purchasing the shares you have the opportunity to take advantage of certain tax benefits that we will discuss later. With this strategy you are exposed to fluctuations in the stock price and it could reduce your ability to maintain a diversified portfolio.
Second, you can exercise and sell your shares immediately. This is a “same day” sale. With the share sales proceeds, you can allocate them to your financial goals, such as funding your child’s college fund, or building a more diversified portfolio.
Third, you can exercise your options through a cashless exercise where you immediately sell some of your exercised shares. A portion of the profits from exercised shares pays for the option costs, and the potential taxes. Then you keep the rest of the proceeds for your financial objectives.
The steps for exercising your ISOs are simple, and the method you choose isn’t. Your best strategy depends on many factors, including your tax situation and your tax strategy.
It’s Up to You
Once your ISOs have vested, you choose when to exercise them. Some factors to consider are how much the shares have appreciated in value, the probability that the company will continue to thrive, and if you need cash soon.
If you sell your ISOs more than two years after the grant date, and more than one year after exercise, you get a “qualifying disposition.” You get a lower, long-term capital gains rate (0%, 15%, or 20%) for a qualifying disposition. If you sell the shares less than two years from the grant date and less than one year from the time of exercise, the sale is a disqualifying disposition and taxed at the short-term capital gains rate (up to 37% federal tax and state tax, if any). Although the tax rate is higher for a disqualifying disposition, you reduce the risk of holding onto your company stock by selling it sooner.
Stock Price Increases and The Power of Options
With ISOs, you can participate in the stock price appreciation of your company stock without using any of your own money.
For example, you have 1,000 shares through an ISO option with an exercise price of $10. Over three years, all 1,000 options vested and the stock price increased to $40. If you exercise your options and immediately sell your shares your profit would be $30,000 before taxes and fees.
ISO Grant Cost -> 1,000 shares @ $10 = $10,000
Value of Shares -> 1,000 shares @ $40 = $40,000
Profit -> $40,000 – $10,000 = $30,000
If at the end of the three year vesting period, the shares are trading at $9, you would not exercise the options (why pay $10 for your ISOs when you could buy the stock for $9?) because they are “out-of-the-money.” Furthermore, you would not have taken on any risk because you don’t own the shares. If you purchased the shares on the market for $9, it would cost you $9,000 (1,000 shares @ $9), whereas owning the options doesn’t cost you anything.
ISO Long Term Capital Gains Advantage
When ISOs have a qualifying disposition, as mentioned above, long term capital gains are in effect. You can lower your tax burden on the sale because long term capital gains tax rates (0%, 15%, or 20%) are lower than short term capital gains rates and ordinary income tax rates (up to 37% federal tax and state tax, if any). Other compensation plans, such as nonqualified stock options are taxed as ordinary income and appear on your W-2. Remember, ISOs have long term capital gains rates taxes, making them a captivating component of your overall compensation package.
Alternative Minimum Tax (AMT) Challenges and Potential Benefits
When you exercise ISOs, you may have to pay the AMT. The AMT is a parallel tax code to the one you are more familiar with. Under the AMT code, when you exercise ISOs, the difference between the exercise price of the options and the market price of the shares at exercise is income and creates an AMT tax liability.
When taxes are due on April 15th, you can have a cash shortage due a surprise AMT liability due. For instance, you can manage this matter by focusing on cash flow and selling shares when you need cash to pay the additional AMT costs. Additionally, you can hold onto a sliver of your shares past the 12 month window so you get a qualifying disposition. With this strategy, you can balance the AMT liability while maximizing the growth in the company stock.
On a positive note, you may be able to take advantage of the AMT credit for the year that you sell your ISOs through a qualifying disposition. The AMT credit could help reduce your tax liability. The AMT is complicated, so it’s best to review your tax situation with a tax professional and your financial advisor.
Partake in the Prosperity of the Business
As an employee who receives ISOs you are a key member of your company. As the company’s stock price increases, the value of your ISOs increases as well.
If you work for a large organization, ISOs build an atmosphere of ownership and pride in the company’s success. Furthermore, ISOs help retain talented employees and boost morale.
There are many ways to use ISOs to your advantage to increase your wealth. They are a powerful mechanism for your benefit, but they can also be complicated and hard to understand. If you are confused, have questions, or would like to go through your option grant together, you can schedule a free consultation.