Incentive Stock Options (ISOs)- US Tax Implications​

Incentive Stock Options - US

US Companies issue various forms of equity compensation including restricted stock units (RSUs), incentive stock options (ISOs) and non-qualified options (NQOs). For early and growth-stage companies, ISOs are the most common form of equity compensation.

Incentive stock options (ISOs) give an opportunity to have ownership in the company. Though ISOs have a favourable tax treatment on exercise understanding your tax obligations and how to minimize your tax burden can be complicated.

How do ISOs work?​

 

  • Incentive stock options give you the option to purchase a set quantity of company shares at a predetermined price.
  • When you are given ISOs, you do not typically receive the shares right away. In most cases, there is a vesting time before you can exercise (buy) the shares of company stock.
  • Once your options vest, it means you now have the right to buy your stock options. The exercise/strike price (based on a 409A ‘fair market valuation’ (FMV) at the time the options were granted) and the number of ISOs issued to you are determined by your employer.

Receiving your ISOs​

 

  • The day the ISOs are issued to you by your company is known as the grant date. The grant date and the vesting date (the day your vesting schedule begins) are not always the same. Typically, the vesting date starts on your first day at the company and the grant date may only happen after you have been with the company for a certain period.
  • A typical vesting schedule looks like 4-years vesting with a 1-year cliff. After that, it may be quarterly or monthly vesting. This means that none of your options vests during your first year, but on the date of your first anniversary 25% of your options will vest. For example, if you have 1,200 options you would vest 300 of them on your first anniversary. After that, every three months you would vest another 75 options.

Taxation of ISOs​

 

The main types of taxes viz the alternative minimum tax and the capital gains tax. ISOs tax implications vary depending on when you exercise your options and how you go about doing it. Generally, the other two popular forms of equity compensation – non-qualified stock options (NSOs) and restricted stock units (RSUs) – are subject to various taxes upon exercise or vesting and  ISOs, on the other hand, are not.

There are two potential taxable events for your ISOs:

  • When you exercise your options.
  • When you sell the shares.

When you exercise your options, you may be eligible for the alternative minimum tax (AMT). When selling your shares, you could be subject to capital gains tax. The amount of capital gains tax you pay depends on how long you have held your shares.

Alternative Minimum Tax


The alternative minimum tax (AMT) ensures that taxpayers pay at least a minimum level of income tax if their earnings are high. If you exercise ISOs, the strike price per share (price you pay) may be lower than the 409A valuation. The difference between the two is your profit which is known as the “bargain element.” You pay taxes on this after a certain amount of ‘profit’ – this is the AMT threshold. Anything below that threshold is tax-free. Everything else is subject to the AMT.

Let us say the 409A valuation is $40 and the strike price is $5. To the IRS you are making a $35 profit per share. That $35 difference, the bargain element, could potentially be taxed. There is an AMT threshold that needs to be crossed for this bargain element to be subjected to the minimum tax. If you are below this income threshold then you do not owe minimum tax on this bargain element.

It is important to note that the AMT only applies to what is known as a qualifying disposition. To have a qualifying disposition, you must hold your shares for at least 2 years from the grant date and 1 year from the exercise date before selling. If they are only held for a time period less than that before selling, it is considered a disqualifying disposition. A disqualifying disposition does not trigger the AMT and you pay regular income tax on the profits.

Capital Gains Taxes


Capital gains are the profits made from selling your shares relative to what you paid for them (or your exercise price). Those profits are then subject to the capital gains tax. There are two types of capital gains:

Short-Term Capital Gains:
These gains are from shares owned for less than 1 year at the time of sale.

Long-Term Capital Gains:
To achieve long-term status, shares must be held for at least 1 year from the date of exercise.

Tax rates on capital gains?

  • Short-term capital gains are typically taxed as ordinary income.
  • Long-term capital gains are taxed at a rate of 0%, 15%, or 20% depending on your taxable income and marital status. Long-term capital gains rates are likely the lowest tax on your company shares. In order to maximize the benefits of your ISOs, it is typically advisable to hold your shares for a year after the exercise date.

Early Exercise – 83(b) election​

If your employer allows you to exercise early, you have the potential to exercise at a much lower tax rate because the 409A valuation may be equal to or close to the strike price. If you early exercise your options as soon as they are granted, you likely will not owe additional taxes (at the time of exercise) because you are buying them at fair market value (assuming there’s no spread between what the stock is currently worth and how much you paid). You must keep your shares for at least 2 years after the option grant date and one year after exercising.

However, it is important to note that you cannot predict how the shares will change in value. If you do early exercise, it is highly recommended that you file an 83(b) election. 83(b) elections make it possible for stockholders to be taxed on the fair market value of their shares at the time when those shares were exercised (typically, a much lower value) rather than when they vest (typically, a much higher value). These 83(b) elections must be filed within 30 days of the exercise date in order to qualify for the special tax rate.
We at 4i Advisory can help you optimize taxes for your ISOs

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