By: Joe Ferreira, Sam Marshall, Jack Rabuck

Stock options are a great way to create alignment between companies and their employees. If the company succeeds, its stock price should appreciate, which in turn increases the value of its employees’ stock options. Everyone’s happy—well, except maybe the IRS… more on that later.

Before we dive in, it’s important to note that stock options come in two main varieties—Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs). If you have stock options or are evaluating an offer that includes a stock option package, understanding whether your options are ISOs or NQSOs is critical. 

This article will cover the basics of ISOs, and a future post will cover NQSOs. For now: What is an ISO?

What is an ISO

At their core, ISOs are pretty straightforward. Each ISO gives you the right to purchase one share of your company’s stock at a fixed price, typically subject to a vesting schedule. Vesting schedules vary, but the most common vesting schedule for ISOs is 25% vesting after Year 1 and the remaining 75% vesting monthly over the next three years. See the example below:

Stock Option Basics What is an ISO

It’s worth noting that if you leave your company, any unvested ISOs will be lost. Additionally, you typically have 90 days after you leave to exercise your vested ISOs, or they, too, will be lost. As you can imagine, this can become a big issue for someone who wants to leave their job but doesn’t have liquidity to exercise their options. For more information, check out this post about when to exercise ISOs.

ISO Taxation

So far so good? Okay, let’s move on to the fun stuff: income taxes. Maybe fun wasn’t the right word… but stay with us. Taxes are where ISOs really shine! By their nature, ISOs meet the requirements set out by the IRS to qualify for preferential tax treatment if you meet the following holding periods:

  • At least two years from date of grant, and

  • At least one year from date of exercise.

In other words, if you exercise your ISOs (purchase your shares) and hold them for at least one year, and at least two years from when they were originally granted to you, then any profit you make when you sell your ISOs will be subject to the much more favorable long-term capital gains tax rate (potentially 20% lower than ordinary income!).

What’s This I’ve Heard About ISOs and AMT?

Ah yes, AMT. You didn’t think the IRS would hand out preferential tax treatment without a catch, did you? 

As we alluded to above, you will pay tax on the profit of your ISOs when you sell them. But it’s also possible to pay some tax when you exercise… enter the Alternative Minimum Tax (AMT)

When you exercise ISOs, you will have AMT income equal to the spread between your exercise price and the Fair Market Value (FMV) of your stock on the day you exercise. If your company is private, the FMV is commonly referred to as the 409a valuation. Depending on your particular tax situation, you may be able to generate a certain amount of AMT income without actually paying any AMT. This calculation can get a bit tricky, so we recommend connecting with your Financial Advisor or your CPA to get a sense of where you stand.

A common mistake to avoid is accidentally creating a large AMT tax bill by exercising ISOs but not having enough cash on hand to pay the tax. This might force you to sell some of your shares before you reach one year from the date of exercise, causing you to lose the beneficial tax treatment altogether.

Recap

In summary, ISOs can be an incredibly valuable part of your finances, especially when you have a plan in place that fits your specific needs. If you need help navigating AMT, or building a long-term plan for your stock options, we’re here to help.

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