Incentive Stock Options (ISOs) Taxes & Strategy
Stock options can make or break your total compensation.
Not just for the potential future appreciation:
But for the resulting tax consequence of not taking them seriously.
Many times, companies keep key executives' actions aligned with shareholder interest through the use of stock options to form a compensation package.
These stock options come in the form of Incentive Stock Options (ISOs), Restricted Stock Units (RSUs), Non-Qualified Stock Options (NQSOs), or cash grants (usually in that order).
If this is you - you’re likely swimming in a sea of information wondering what to do.
Or:
Despite your best efforts, you exercised some options and now got hit with a $90,000 AMT tax bill (like a recent prospect (now client) I’m currently working with experienced) and now are scrambling to find a way to pay for that tax bill.
There are five components to consider with ISOs:
Grant date
Strike price
Vest date
Exercise date
Sale date
Grant date is the date your options were granted to you.
Strike price is the price your option can be exercised.
Vest date is the date your options actually become yours.
Exercise date is the date you use your option right to purchase shares (you purchase shares at the stock’s fair market value).
Sale date is when you eventually sell the exercised shares you purchased.
The thing to note with your shares is that your vesting schedule may be either graded or a cliff.
Meaning:
Graded = vested over time (ex: 20% over 5 years)
Cliff = 100% vested at specific time (ex: 3 years then 100% vest)
When your shares vest (however that may be) you can then exercise your shares.
When you exercise your shares, you will have to purchase the number of shares at the designated strike price (ex: 2,000 shares at $15/share strike = $30,000).
This is actually a great deal.
Why?
Because you’d only exercise the shares if you’re making money.
In the stock option world, this is called, “in the money” or “out of the money.”
You would only exercise your shares when they’re in the money because otherwise, those shares are worthless.
When you exercise your shares, not only do you have to pay for those shares, but you also likely have to deal with something else:
Alternative Minimum Tax (AMT)
While the cost upfront to pay for those shares is the number of shares exercised multiplied by the strike price of your ISO - the AMT tax is a bit more complicated.
AMT is a secondary tax calculation to ensure high income earning individuals pay their fair share of taxes - you’ll either pay the higher of regular tax or AMT.
Exercising your incentive stock options is one key add-back in the AMT calculation that makes it more likely you’ll owe AMT tax.
Reason being:
When you exercise your vested shares, the spread between the strike price and the fair market value at exercise is included in your income for purposes of determining AMT tax (this is commonly referred to as the bargain element).
& yes, you’re paying tax for something you haven’t yet sold. The reason for this is due to the tax favorable nature of ISOs (paying capital gain tax rates over ordinary income tax rates on spread between the strike price and the sale price in a qualified disposition (more on that later)). If you didn’t owe AMT tax, you’d see more executives being primarily compensated with ISOs because they’d pay less tax than had they just been paid wage income (which is also why the amount of ISOs you can be awarded is limited to $100,000 per year).
Consider the ISO bargain element in action:
1,000 shares vest at $15/share exercise price when the fair market value is $20/share. $5/share is your bargain element. Multiplied by 1,000 means that $5,000 is your bargain element (small example but if you scale this up - that becomes a big pill to swallow).
In 2023, AMT is a nearly flat tax rate of 26% for the first $220,700 and any amount in excess is taxed at 28%.
If you don’t sell your shares within the same calendar year, that bargain element created from exercising your ISOs is subject to AMT (you can actually avoid AMT if you exercise and sell your shares within the same calendar year).
While AMT is really a prepayment of expected taxes due, the reason why you’d deal with this is because the benefits of ISOs relative to other forms of stock compensation (Non-qualified stock options, RSUs, or PSUs) is the ability for long-term capital gain treatment at sale from the difference between the exercise price and the sale price.
This is called a qualified disposition.
In order for you to receive the favorable long-term capital gain treatment, two things must occur:
You have to hold the option for one year from exercise.
You must hold the option for two years from the grant date.
Achieving long term capital gain treatment over ordinary income treatment could mean the difference in hundreds of thousands of dollars in tax savings.
In the event you don’t satisfy the one year from exercise and two years from grant date requirements, the ISO is now deemed a disqualified disposition and you lose the favorable long-term capital gain treatment on the bargain element.
In a non-qualified disposition the bargain element is taxed as ordinary income and your holding period after exercising the option will determine whether you pay short or long term capital gains rates (greater than 1 year = long-term capital gain & less than 1 year = short-term capital gain or ordinary income rates).
On top of this, if you have a qualifying disposition for your ISO then not only are you getting the favorable tax treatment, you can get some or all of the AMT paid back to you as a credit.
Let’s just say you ended up owing a $210,000 AMT bill from exercising your ISOs, then you sell them as a qualifying disposition at $150,000 then the $60,000 spread is an AMT credit you can use on your tax return (simplified example).
It’s important to note, that you cannot owe AMT in the year you realize the AMT tax credit - so if you’re exercising your ISO’s systematically throughout the year then your AMT credit will carry forward on your return until you’re not subject to AMT taxes.
As you can imagine, when it comes to strategy around how to realize ISOs - there’s more than one way to do this & the right answer will depend on your goals, expectations of company future performance (&/or desire to hold the stock), cash on hand, type of options granted, etc.
With that in mind, here’s some items I’d consider in a ISO strategy:
Exercise early in the year so you give yourself the option of selling your shares before year end to avoid AMT the following year. If the stock price is lower, selling your shares early may result in an after-tax savings (even if you’re paying higher ordinary income tax rates relative to long-term capital gains rates).
Know the stock price after-tax breakeven number for when to sell your shares to attain a disqualified disposition.
Qualified dispositions and long-term capital gains rates sound great (& they are) but if you’re dealing with company stock that is precipitously falling in value it may be better to just cover your losses.
Exercise ISO shares up until the AMT exemption crossover point. Depending on the amount of ISOs you’re exercising, you could exercise them and not be subject to any AMT tax.
But be mindful of the AMT phaseout range. If you’re a highly compensated individual and you’re realizing $200k+ of ISOs, if your income grows over the AMT phaseout of $1,047,200 for married filing joint borrowers, you’ll lose $1 of exemption for every $4 of income until your exemption is zero.
Be mindful of your capital gains tax rate. If you’re in the 37% marginal ordinary income bracket, your capital gains rate increases from 15% to 20%.
Not to mention, when you’re over $250,000 of married filing joint modified adjusted gross income, you’ll owe an additional 3.8% net investment income tax.
Knowing where you’ll end up tax wise, is a great way to ensure you’re not paying more tax than you should.
Review your strategy for all vested stock options. Use your RSUs and NQSO to help pay for your ISO AMT tax bill. If the goal is to utilize ISOs for qualified dispositions (stock price permitting), then using other stock options that are not as tax advantageous as ISOs is a great tool to get the most return from your ISOs.
Use a cashless exercise of ISOs to manage cash flow (using some of the proceeds generated by exercising and then selling a portion of your ISO shares).
Review the possibility of accelerating your AMT tax credit → when you sell your ISO shares in a qualifying disposition, you might be able to receive your AMT back in the form of a credit.
Above all –
Planning for equity compensation can be complicated but with the right plan and education - you maximize your equity compensation return, reduce how much tax you pay, and make strategy painless.