Stock options are one of the more popular forms of equity compensation. They give employees the opportunity to buy company stock at a built-in discount while also possibly enjoying tax advantages.
There are two types of stock options, Incentive Stock Options (ISOs) and Non-statutory Stock Options (NSOs). Which type you hold will largely dictate your strategy around holding, exercising, and selling your stock.
In this article, we’ll focus primarily on ISOs. Also referred to as qualified stock options, ISOs can be granted only to employees of a company (independent contractors are not permitted).
While many people get excited about options and what their value might mean for their financial future(s), it’s good to remember there are certain strategies you can either implement or avoid to ensure you are getting the outcome you desire.
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With an ISO, employees are allowed to purchase company stock at a predetermined price (known as the exercise price) for a set period of time. If the current market price is higher than the exercise price, the options have value. But if the current market price is lower than the exercise price, the options have no value and are considered to be “underwater.”
ISOs are typically valued on the grant date, and employees can choose when to exercise their right to buy them. Once the options are exercised, they begin their holding period. Depending on the company, employees can hold and sell later, may be required to hold until a liquidity event, or may be able to sell immediately. Stock options also feature an expiration date — if they aren’t exercised before this date, they vanish.
In most instances, ISOs are subject to a vesting period; employees must wait until the options have vested before they can exercise them. The most common vesting schedule is annual vesting. For example, on a five year vesting schedule, employees vest one-fifth of their options each year.
Employees can pay cash upfront to exercise their ISOs or sometimes use a cashless exercise, which sells some options in order to exercise others. A cashless exercise can be a useful way to exercise some options when the actual cash exercise cost is too high.
Companies don’t always offer ISOs due to their complex tax treatment, but when they do, ISOs can bring special tax benefits to employees.
Tax Treatment of ISOs
ISOs potentially have more favorable tax treatment than other types of employee equity compensation as long as certain requirements are met.
If you hold the shares longer than two years from grant and one year from exercise, you could qualify for preferential long-term capital gains treatment upon sale. If you don’t meet this requirement, then the sale will be treated as a disqualifying disposition and gains are treated as ordinary income.
While ISOs are not taxed for regular tax purposes until they are sold (if you meet the holding requirements), the alternative minimum tax (AMT) may apply if you exercise and hold the shares past year-end. The bargain element (the difference between the grant price and the exercise price) is considered AMT income in the year that you exercise your ISOs.
But AMT doesn’t have to be the end of the world, as long as you can afford to pay it. It’s not an extra tax as much as it’s an acceleration of tax you would have to pay anyway. If you pay AMT after exercising options, you may be entitled to an AMT tax credit that can be used to lower your tax bill in subsequent years. It’s advisable to speak with your tax advisor or CPA to understand if this is applicable to you.
How to Exercise ISOs
ISOs can be a bit trickier to exercise than NSOs because tax consequences depend on how long you hold the shares.
If you hold on to your shares for the qualification period (two years after grant, one year after exercise) and things go well, then you will likely only owe long-term capital gains tax when you sell. You may, however, still need to put up a sizable amount of cash upon exercise, both to purchase the shares and pay any AMT if it applies. And it’s possible your stock’s value could just as easily go the other way, which means you would erase any potential gains – and in some cases, may have to pay out of pocket to cover taxes.
Understanding the value of your ISOs, their vesting requirements, and your exercise strategy are crucial elements of a successful financial plan around employee equity. Next steps for you?
Learn more with Personal Capital’s free guide to employee equity compensation.
Consider speaking with Personal Capital’s dedicated financial advisors, who can help sort through the oftentimes complex circumstances surrounding employee equity compensation.
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