Stock Options and Taxes – An Introduction

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As the number of start-ups 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 and more common in employment contracts.  Although many will use this term often in conversations across the Bay Area, few truly understands what it is and the consequences of what it can do to the bottom line on the income tax return.  For this segment, we would like to equip our readers with better tools for early tax planning, by delving into the depths of Incentive Stock Options (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.  ISOs 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), and 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 (we will discuss the AMT trap later in this segment). 

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 what the current fair market value (FMV) of the shares are. 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.  The employee can either exercise and sell right away, or exercise and hold on to 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.  How it is divided depends 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 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).

Below is a simple example of the tax consequences of ISOs.

Assumptions:

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 Alternative Minimum Tax (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 the employee will owe AMT or not depends on the employee’s 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).  Please 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 two years after the grant date. 

Hopefully, this segment has helped clear up some confusion regarding ISO taxation.  Please stay tuned for our next segment.  We will be covering Non-Qualified Stock Options.