As the number of startups hit new heights in the Silicon Valley and various companies are utilizing equity to help attract, retain, and motivate skilled workers, the term “incentive stock option” is becoming more common in employment contracts. Although many will use this term often in conversations across the Bay Area, few truly understand what it is and the consequences it can have on the bottom line on the income tax return. We would like to equip you with better tools for early tax planning by delving into the depths of incentive stock options (ISOs).
Qualifying for an ISO
Due to the favorable IRS tax treatment, an option must jump through many hoops to qualify as an ISO. Beginning with the 100K rule, an employee is limited to receiving a maximum of $100,000 of ISOs per year. With this rule,
- ISO shares may not be transferred
- Special tax qualifications may be lost through modification
- Exercise price must be at least fair market value (110% of FMV if the option holder is a greater than 10% shareholder)
- The terms may not exceed 10 years (5 years if the option holder is a greater than 10% shareholder).
Once an option qualifies as an ISO, the option holder will not incur any regular income tax liabilities on the grant date, vesting date, or exercise date.
How and When ISOs Are Taxed
Now that we have discussed when ISOs will not be taxed, let’s start looking into the details of when and how ISOs are taxed. When ISO shares are granted (grant date), the price per share must not be less than the fair market value of the stock at the time the option is granted. This price is commonly known as the strike price. This is the price the employee would be paying to exercise the ISO shares.
On or after the day the ISO shares vest (vest date), the employee owns the right to purchase the vested shares from the company at the strike price, regardless of the current FMV of the shares. The difference between the FMV of the ISO shares on the exercise date and the price the employee actually paid for the ISO shares is called the spread. Once the ISO shares are exercised, the employee has two choices: they can either exercise and sell right away, or exercise and hold onto the ISO shares to be sold on a later date.
If the employee exercises and holds the ISO shares, the spread is not subject to regular income tax. If the employee holds the ISO shares beyond the tax year the ISO shares were exercised, the spread is added to the employee’s income for the purpose of calculating alternative minimum tax (AMT). This may subject the employee to an AMT liability. It is recommended the employee contact a tax professional when ISO shares are exercised, to prevent a surprise tax bill at filing time.
At the time the ISO shares are sold, the employee will need to report the difference between the selling price and the cost basis of the ISO shares as income. Unfortunately for ISO shares, this income must be divided into two types, which depend on whether the sale is classified as a qualifying disposition or non-qualifying disposition. In order to be classified as a qualifying disposition, the employee must have held the stock more than 2 years from the grant date and more than 1 year from the exercise date.
In addition to these rules, the employee must also be continuously employed by the employer up to three months (1 year if the employee is disabled) prior to the exercise date. Under a qualifying disposition, the income would have special long-term gains treatment and will be taxed at 15% for federal (20% if the employee is in the highest federal tax bracket). Please be aware that capital gains may also be subject to the additional 3.8% Net Investment Income Tax.
If the ISO shares were classified as a non-qualifying disposition, the spread will be taxed as compensation on the W2 (subject to employment tax and withholding) and the gain (the difference between the sale proceed and the FMV on the exercise date) will be taxed at the short-term capital gain rate, if held under one year, or long-term capital gain rate, if held over one year.
Possible Tax Consequences of ISOs
- Grant date: January 1, 2017
- Shares granted: 100
- Strike price: $10
- Fully vested and exercised date: January 1, 2018
- Fair market value on January 1, 2018: $15
- Fair market value on June 1, 2018: $21
- Fair market value on January 2, 2019: $25
Under these assumptions, the employee will not have to pay regular income tax on January 1, 2017, when the ISO shares are granted. If the employee decides to exercise all 100 shares on January 1, 2018, the employee will not trigger any regular income tax liability at this time, either. The employee will just have to pay $10 per share for the 100 ISO shares exercised.
However, this is where the AMT trap comes in. If the employee does not sell the ISO shares before December 31, 2018, the employee may be subjected to paying AMT on the difference between the strike price and the fair market value on the exercise date. In this case, this spread is $5 per share ($500 total). This amount will be added to income only for the purpose of calculating AMT (and will increase the cost basis for these shares to $15 for AMT calculation purposes when they are sold later). Whether or not the employee will owe AMT depends on their tax status for that year. It is always a good idea to connect with a tax advisor before deciding to exercise ISO shares.
If the employee sells the ISO shares on June 1, 2018, the spread will not trigger AMT for this transaction. However, the employee must pay regular income tax and employment tax on the spread ($500), then pay short-term capital gains tax on the difference between sale proceed ($21*100 shares) and the stock cost basis ($15*100 shares). This is a non-qualifying disposition, which we discussed earlier.
If the employee sells the stocks on January 2, 2019, it would be considered a qualifying disposition. In this case, the employee may have been subjected to AMT on December 31, 2018, and would pay long-term capital gains tax on the difference between the sale proceed ($25*100 shares) and the cost basis ($10*$100 shares). Remember, to qualify for long-term capital gain treatment on both the gain and the spread, the employee must hold the shares for a minimum of 1 year after the exercise date and 2 years after the grant date.
Hopefully this has helped clear up some confusion regarding ISO taxation. For continued financial management tips and updates, subscribe to our blog and check back for new content.