Stock Options Made Simple: What Do You Need To Know About ISOs?

Equity compensation is one of the most important levers employers use to attract, retain, and incentivize their employees. However, while equity compensation can be a valuable tool, it can also be confusing. We’re about to change that. Our three-part equity compensation series breaks down the basics of the most common types of equity compensation, starting with incentive stock options (ISOs). Stock options can genuinely augment the efficacy of your compensation package. If your employer offers you stock options, how can you make the most of them?

What Are ISOs?

Incentive stock options are a popular form of equity compensation, which allows employees to purchase company stock at a predetermined price in the future. Some critical ISO terminology includes:

• Grant Date: The date your ISOs were issued or offered to you by your employer. It often starts the clock on the ISO expiration date.

• Vesting Schedule: It marks the time when you’re eligible to buy the stock. Your vesting schedule outlines the strike price, number of shares in each grant, dates for exercising, dates for vesting, etc.

• Strike Price (also known as the Grant or Exercise Price): The price per share set by your employer at the grant date. It’s common for the strike price to reflect the stock’s fair market value at the grant date. Simply put, it’s the predetermined price you’ll pay for the shares.

• Exercise Date: The time when you exercise the right to buy the ISOs.

• Fair Market Value: The current value of one share of common stock.

• Bargain Element (or Spread): The difference between the strike price and the fair market value on the exercise date.

• Clawback Provision: Essentially, these provisions allow a company to recoup the money they’ve already paid to an employee. A clawback provision may stipulate that your employer could recall the options if you leave the company.

ISOs vs. NSOs

There are two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). It’s essential to understand the differences so you can create a strategic plan. First, ISOs have an expiration date of 10 years, and NSOs don’t expire. Additionally, incentive stock options come with important tax benefits. While we’ll dive deeper into ISO tax liability, the primary difference is that profits from the sale of your ISOs are eligible for capital gains tax rates, which could result in significant savings. NSOs come with less favorable tax rules since you’re taxed at ordinary income rates when you exercise and sell the shares. 

How Are ISOs Taxed?

Your ISOs tax life cycle centers on two events: exercising the options and selling the shares. The resulting tax treatment depends on when you exercise, how long you hold the stock, the strike price, and the fair market value, among others. ISOs come with complex tax rules, and as such, it’s critical to work with your financial planner and tax professional to provide in-depth tax planning advice. Below are the basics. 

Qualifying Disposition

When you sell your ISOs, ensure you engage in a qualifying disposition. As long as you hold the stock for at least 2-years from the grant date and 1-year from the exercise date, profits are taxed at the more favorable long-term capital gains tax rate. It is critical to meet both conditions for the IRS to consider the sale “qualified.” NSOs lack this preferential tax treatment.

Disqualifying Disposition

In the case of a disqualifying disposition, some of the stock’s value could be counted as income at the exercise date, and the profits from the sale would be taxed at ordinary income tax rates, which can be as high as 37% on the federal level!

Alternative Minimum Tax (AMT)

Finally, be aware of triggering AMT when exercising your ISOs. In the year you exercise your options, you must report the bargain element as taxable compensation for AMT purposes.

Should You Purchase All of Your Options? (Plus, Tips to Finance it)

Remember, ISOs offer you the “right” and not the “obligation” to purchase company stock. Before your options vest, consider how many you want to purchase and how you plan to pay for them. In general, you have a couple of options:

1. Buy shares outright: Once your shares vest, you can purchase your company stock at the strike price. Your total cost would be the strike price multiplied by the number of options you exercise. Say 1,000 shares vest next month, and the strike price is $10 per share. If you wanted to purchase all of them, you’re looking at shelling out $10,000 in cash.

2. Cashless exercise/Same-day sale. If you don’t have all the cash on hand to exercise your shares, you can look at a cashless exercise, where you exercise the options and then immediately sell the shares to pay the bill. Doing so enables you to cover your costs with the sale proceeds. 

Both options have their merits and drawbacks. Buying the shares outright adds company stock to your portfolio, which can be an excellent opportunity. But watch out for overconcentration. It’s best to create a plan that encompasses your goals to ensure you have the right balance of company stock to your name. Cashless exercises get a bit more in the weeds, depending on how you execute them. Some employers offer cashless exercise programs where a brokerage firm provides a loan to exercise your options. Once you do, you’ll sell the shares, pay back the loan (including commission, fees, taxes, etc.), and keep the profits. Keep in mind that by selling shares immediately, you’ll likely be on the hook for ordinary income tax on the spread. You may also be able to exercise your ISOs before they vest. Doing so comes with some potential advantages, like paying taxes on a lower fair market value (file an 83b election) and starting the long-term capital gains tax clock. But it’s a risky move since you’ll invest in a share you don’t own. No matter the route you choose, you must thoroughly understand the tax implications of your decision. 

3 Ways to Maximize Your ISOs

Your ISOs can be valuable assets, making it important to capitalize on the best benefits for you.  Below are three tips to consider when building your ISO strategy.

Know Your Financial Goals

Your financial goals should help inform your stock options strategy. Knowing the end goal will give your financial team greater insight into the right strategy and trade-offs for you.

• Do you want to use the proceeds for big financial goals like a down payment on a new home or savings for your children’s college?

• Is your eye set on an earlier retirement?

• Will you hold the shares as part of your long-term investment plan?

Understanding how you want to use the shares makes building a strategy around it much more intentional. You’ll be in a much better position to decide when and how much you should exercise your options. 

Make a Plan for Exercising and Selling Your Options

ISOs come with several moving pieces, so the first step is to gather all the necessary information about your options (take a look at the key dates above to get started). Your financial team can analyze these data points and run scenarios to develop a plan that best aligns with your financial vision. Remember, no one can predict how the company’s stock will perform, so it’s best to build a plan that encompasses your risk tolerance and capacity, time horizon, goals, and more. While being financially invested in your company can be positive, there is also the tendency to over-concentrate. Be cognizant of your allocations so you don’t tie too much of your net worth to one stock.  

Consider Tax Consequences

ISOs come with inherent tax benefits, so it’s often good to take advantage of them when it makes sense. For starters, aim for qualifying dispositions. You will be taxed at more favorable capital gains rates by holding the shares for the minimum period. You’ll also want to remain conscious of generated income when exercising and selling your shares. Always plan for estimated tax payments so you aren’t surprised by April. If you have ISOs and your company plans to go public soon, it could result in a significant tax impact. The key is to make a multi-year plan which aims at maximizing your options and minimizing taxes.

Work With a Professional

Navigating through your equity compensation can get highly complex, and ISOs are no exception. While a captivating wealth-enhancing perk, planning for ISOs is all but straightforward. Creating a solid strategy starts by understanding your goals and making the most of your resources to help you reach them. At The Dala Group, we are well-versed in guiding our clients to create efficient and effective plans for their equity compensation. We would love to help you build a plan for your ISOs. Reach out today.