ISOs (Incentive Stock Options) are powerful mechanisms to improve your financial life. They also have a complex tax structure. In this post, we’ll go over the intricacies of ISOs and taxes.
ISO Tax Advantage
ISOs are a special kind of stock option that has preferential treatment in the tax code. As long as you own the option at least one year from grant and then one year from option exercise (two years total) you pay the long term capital gains tax rate.
This is a great way to reduce your taxes but you also have to own your company shares for at least two years.
Tax Incentive Risk Reward
As you own your shares over two years, or maybe longer, the stock price can fluctuate quite a bit. Hopefully it goes up! Sadly, sometimes share prices decline. If you wait two years for the tax incentive on ISOs, you could be selling your shares at a much lower dollar amount.
On the other hand, if you sell the shares right away at a higher share price you could have more money in your pocket despite paying higher taxes on the disqualifying ISO disposition.
How can you determine what to do? Work with a financial professional to develop a strategy around timing the sale of your ISOs.
Potential AMT
Although ISOs have a lower long term capital gains rate, you may have to pay the AMT (Alternative Minimum Tax), especially if you exercise and hold a significant amount of ISOs. When you pay the AMT, you will generate an AMT credit that you can use to offset future tax liabilities. The AMT and AMT credit are very complicated, and it’s best to consult with a CPA about them.
ISO $100k Limit
As an employee you can only receive $100k in ISOs per calendar year. This applies to the total value of ISOs that are scheduled to become exercisable within a single calendar year.
Said another way, the ISO $100k limit applies when the option is granted. Let’s walk through an example to illustrate.
- ISO of 100,000 shares
- Fair market value (FMV) of shares is $2
- 4 year vesting (25,000 shares per year)
In year 1 of the grant, the value of the option grant is $50,000 (25,000 shares x $2).
This does not violate the $100k rule.
On the other hand, if the entire grant is eligible for early exercise, then the year 1 option grant is $200,000 (100,000 shares x $2) exceeding the $100k limit. At this point you will have to speak with the company about splitting the grant to 50,000 ISO shares and 50,000 NSO shares.
Bringing it All Together
ISOs and taxes are very complicated and it’s best to develop a plan with a professional so you can use them to your advantage. When you have a strategic plan you can reduce your taxes throughout your lifetime and more importantly, reduce your stress. If you would like, we can chat about a plan.