8 Tips If You're Being Compensated With Incentive Stock Options (ISOs)

15 MIN READ

If you have a job at a company that offers incentive stock options (ISOs), you may be excited and curious about how to understand, exercise, and benefit from them. ISOs are the most common type of stock option, although, under certain circumstances, your employer may offer you non-qualified stock options (NSOs or NQSOs) which are taxed differently.

The best part about ISOs is the ability to defer taxes until you sell the stock.

#1: All About ISOs

So what is an ISO?

An incentive stock option (ISO) gives you the right (but not the obligation) to purchase your company’s stock at an Exercise Price subject to certain conditions. The date your employer issues the ISO is called the Grant Date.

When you receive the ISO, you can’t use it to purchase stocks right away. You still need for the options to vest. This means that you have to stay with the company for a certain period before you can exercise or use your ISO to buy stocks.

On the Grant Date, your employer will determine the Exercise Price (aka the Strike Price) of your ISO. The Exercise Price of your ISO is the price at which you can buy your company’s stocks after it has vested on a future date. The day you use your ISO to buy the stocks is the Exercise Date.

How do companies set the Exercise Price?

The Exercise Price for the ISO should not be lower than the market value for the stocks at the grant date.

How do ISOs work?

When your company issues an ISO, they will specify how many shares you can buy at the Exercise Price. After receiving the ISO, you need to wait for the option to vest before you can use it to buy shares.

Many companies have a four-year vesting schedule with a “one year cliff.” A one year cliff with four-year vesting means that you will only have access to the first 25% of the shares you were granted after the end of your first year and nothing before that. After that, vesting will happen monthly or quarterly with 25% of the ISOs vesting per year. Note: 25% vesting schedules are the norm. However, some firms may have a different vesting schedule, such as, 20% in Year 1-3, and 40% in Year 4.

Here’s an example.

Company Z grants you an ISO that allows you to purchase 1,200 shares at an Exercise Price of $5. This ISO has a four-year vesting schedule, assume 25% vesting per year.
On the first year, you can buy 300 shares (25% of 1,200) if you wish. After that, if it vests quarterly, you can buy 75 shares (3/48 multiplied by 1,200) by exercising your options for each quarter after the first year.
After four years, your ISO has fully vested. On Year 4, the market value of the stock happens to be $15 per share and you decide to exercise your ISO.
Since the Exercise Price of your incentive stock option is $5 per share, you only have to pay $6K (1,200 shares multiplied by $5) to acquire 1,200 shares instead of $18K (1200*$15)! So, you bought 1,200 shares of your own company at a $12K discount. Nice!
If you sell at the current market price, you can convert the $12K discount to cash immediately. Depending on your goals (and the tax consequences, discussed later), you may also hold the shares for a longer period before selling them.

Some ISO Rules You Should Know

Every year, you can only exercise ISOs valued at up to $100K. This limit is based on the stock value at the date of grant. Above this threshold, granted options will be treated as a non-qualified stock options (NSQO). NQSOs do not receive the same preferential tax treatment as ISOs. Continue reading for more about ISOs and taxes.

#2 Taxes With ISOs

Before you determine how taxes for your ISOs will work, you need to determine if the eventual sale of your stock is a qualifying or disqualifying sale event (also known as a disposition).

Qualifying Sale Event of an ISO

Your sale is Qualifying if
You held the stock for longer than two years from the GRANT date, and
You held the stock for longer than one year from the EXERCISE date, and
You exercised the shares within three months after you severed ties with the employer granting the ISO. Note: If you left because of a disability, the exercise date should be within a year after you left your employment.

Taxes On A Qualifying Disposition

Capital Gains Tax: The taxable capital gains would be the difference between the selling price and the exercise price. You may also deduct any brokerage fees or commission from the selling price. The capital gains from the sale will be subject to capital gains tax which could be either 0%, 15% or 20% depending on your income bracket.
Ordinary Income Tax: None. If the disposition meets all the conditions of a qualifying sale, your employer will NOT report it on your Form W-2 and you will not owe ordinary income taxes. Instead you will receive a 1099-B.

Disqualifying Sale Event of an ISO (Not to Be Confused With a Non-Qualifying Stock Option)

If the transaction doesn’t meet all the conditions above, it is a disqualifying distribution. The bargain element, that is, the difference between the market price and the exercise price will be treated as ordinary income and reported in your W-2 Form as part of your total wages or added to Line 7 of Form 1040.

Taxes On A Disqualifying Sale Event Made On The Exercise Date

Ordinary Income Tax: You will pay ordinary income tax on the bargain element.
Short Term Capital Gains Tax: Since this is a disqualifying disposition and the shares were sold less than one year from the exercise date, the difference between the selling price and the exercise price will be taxed at short term capital gains rates which are the same as ordinary income tax rates.

Taxes On A Disqualifying Sale Event Less Than 1 Year From The Exercise Date

Ordinary Income Tax: You will pay ordinary income tax on the bargain element.
Short Term Capital Gains Tax: Since this is a disqualifying disposition and the shares were sold less than one year from the exercise date, the difference between the selling price and the exercise price will be taxed at short term capital gains rates which are the same as ordinary income tax rates.

Taxes On A Disqualifying Sale Event More Than 1 Year From the Exercise Date But Less Than 2 Years From the Grant Date

Ordinary Income Tax: You will have to pay ordinary income tax on the bargain element.
Long Term Capital Gains Tax: Since the shares were sold greater than 1 year from the exercise date, the difference between the selling price and the fair market value of the ISO shares at the Exercise Date is subject to the lower long term capital gains tax which could be either 0%, 15% or 20% depending on your income bracket. The long-term capital gains will be reported on Schedule D of your tax annual tax return.

What if I sold the shares at a price lower than the market value at the exercise date?

If the sales price is lower than the market value at the exercise date, you may use the difference between the lower sales price and the exercise price unless:

It was a wash sale where you repurchased shares in the same company 30 days before or after you sold the shares.
You sold the shares to a related party such as a family member or a partnership or corporation where you own more than 50% interest
You donated the stock to a charity or an individual

Do I have to pay taxes when I exercise ISOs?

No, you only pay taxes when you sell the stock. However, at the exercise date, you have to report the transaction on Form 6251 Alternative Minimum Tax.

#3 The Best Time To Exercise ISOs

When is the best time to exercise your ISOs?

Deciding when to exercise and sell your ISOs depends on your goals.

Minimizing Risk

Working for a company and holding that company’s stock may put you in an overexposed and undiversified position. If something happens to the company, your employment may suffer. At the same time, stock prices may take a hit.

Hence, you may prefer to exercise the options right away. If you don’t have the cash on hand to buy the shares, you may enter a cashless exercise (see below).

Minimizing Ordinary Income Tax

If you are a high-income earner you may want to avoid being taxed at ordinary tax rates. The maximum income tax rate which applies to individuals with a taxable income of over $612,350 (joint filers) or $510,300 (single filers) is 37%.

If minimizing ordinary income tax is your priority, you should focus on meeting the requirements for a qualifying disposition. This means that you have to wait for a minimum of two years from the ISO grant date and at least a year from the exercise date before you sell your ISO shares. In qualifying disposition, the sale will be taxed as long-term capital gains, the maximum rate of which is only 20%.

Minimizing Unknown Future Capital Gains Taxes

The Tax Cuts and Jobs Act retained the preferential treatment for long term capital gains tax but this may not always be the case. Congress will revisit most provisions in the new tax law in 2025. By then, there might be changes in the treatment of ISOs, the holding period for long term capital gains, or the tax rate.

If you wait longer to exercise, a new tax law may increase your capital gains tax.

Minimizing Alternate Minimum Tax

Exercising your ISO may trigger the alternative minimum tax (AMT). The best way to think about AMT in the context of ISOs is prepaid income tax on the exercise of stock options (not the sale). In the year you exercise, the bargain element is added to your income for the purposes of calculating whether you will owe AMT and how much you will owe. The problem with this is that you may incur AMT before you sell stock and recoup the cash you need to pay the tax bill. In certain situations, the stock may fall before you can sell it, leaving you holding the AMT bag.

On the year you exercise your option, you may have to pay the AMT if your income for AMT purposes is more than $71,700 (single filers) or $111,700 (joint filers).

AMT is levied at two rates: 26% on the first $194.8K (married filing jointly) and $97.4K (married filing separately). Above this threshold, your AMT is imposed at 28%.

It is often recommended to exercise ISOs in January in order to give yourself time to amass cash from January to December to pay the AMT the following year.

If your sole priority is minimizing AMT, you should sell your shares in the same year as you exercise your options. You do not need to make an AMT adjustment if you exercise and sell in the same year. The sale will be a disqualifying disposition and you will pay ordinary income tax. It will not be considered for AMT purposes.

Anyone planning to exercise and sell on the same year should take note of possible “lock-out period” rules that may apply to you, particularly if you are a senior executive. If you exercised the ISO but are prohibited from selling the shares, you may trigger AMT.

Computing the AMT can be tricky. An experienced tax advisor like MYRA can help you determine whether it would be more beneficial to take a disqualifying disposition or to exercise and hold, possibly incurring AMT.

Maximizing The Value of The Stock

If you want to profit from the appreciation of your company’s shares, hold the

ISO as long as your company is performing well. Since your goal is capital appreciation, you may want to exercise your ISOs and purchase your company’s shares on the year you plan to sell those shares. If you do this, the transaction would be a disqualifying disposition which is subject to ordinary income tax rates. Note that the exercise-and-hold strategy may result in AMT.

Changes In The New Tax Law Might Change Your ISO Strategy

New tax changes increased the exemption limit for AMT. This means that you will be able to exercise more ISOs before triggering AMT. In addition, this may cause companies to issue more ISOs.

#4 How Are ISOs Different From Other Types of Stock Compensation?

How are ISOs different from Nonqualified Stock Options (NQSOs)?

NQSOs do not qualify for preferential tax treatment. Unlike ISOs which can only be given to an employee, NQSO may also be given to contractors, directors, and consultants. When you exercise NQSOs, the difference between the fair market value at the exercise date and the strike price will be included in Form W-2 or 1099-MISC for contractors as part of your ordinary income. Your employer will also withhold Social Security and Medicare taxes from this income (independent contractors will have no withholding). When you sell the stocks, you have to pay capital gains tax.

How are ISOs different from Restricted Stock Units (RSUs)?

When an employer gives employees RSUs, they are actually giving the employee real shares, not options to buy shares. For RSUs, upon vesting, the employee is not required to make any payment to acquire the stocks. With ISOs, you actually have to buy the shares at the exercise price to acquire the stocks.

Another difference lies in taxation. When the RSU vests, it becomes taxable. Meanwhile, the ISO will only be taxable when you sell the stocks, except as it pertains to the AMT caveat discussed earlier.

#5 If You Don’t Have The Funds To Exercise Your ISOs, There Are Options

If you don’t have the funds to exercise your ISOs, look into whether your employer offers a “cashless exercise” option for their employees.

Most employees who receive ISOs opt for cashless exercise because it may be too expensive to exercise your options and buy lots of shares of your company with money from your pocket. A cashless exercise involves two transactions – exercising the shares and then selling them right away in one fell swoop. This is facilitated by a brokerage firm designated by the employer.

In a cashless exercise, the brokerage firm will shoulder the cost of buying the shares. On the same day, the firm will also sell the shares to the open market. The firm will deduct the cost of the shares, commissions, interest, withholding tax, and other fees from the proceeds of the sale. The employee will only receive the net amount from the transaction.

Cashless exercise is a disqualifying event where there is no gain or loss. You will not pay taxes for the disposition but you still have to pay ordinary income tax on the bargain element. This income will be reported on Box 1 of your 2018 Form W-2 or on line 7 of your Form 1040.

#6 If You Leave Your Employer, There Are Rules You Have To Follow Regarding Your ISOs

When you leave your company, you have to exercise your shares.

You can purchase stocks up to 90 days from the date you leave your employer. However, some startups have started to increase the exercise window to seven years because their employees don’t have the funds to buy their shares within 90 days of leaving. Even if your employer allows you to exercise the option beyond this period, it will be treated as a non-qualified stock option and taxed at ordinary income tax rates.

If you left because of a disability, this period extends to one year.

You may also be able to sell your exercised options to a private investor like ESOFund, SharesPost, or Second Market if your employer permits it. If you are unable to afford to buy all of our options, a private investor may fund the purchase.

Many clients ask us what they should do with ISOs and what the tax consequences are if they move back to their home country. If you leave the US permanently, you may be able to avoid some taxes on your US-based ISOs. When you exercise qualified stock options, there is no ordinary income tax, so you will owe no tax on the bargain element. If you sell your shares in a disqualifying event, you will owe ordinary US income tax on this US-based income even if your live in your home country because the income is still “effectively connected” to your work in the US. Nonresident aliens do not pay US capital gains tax so you will not owe any tax on the capital gain of the shares.

#7 ISOs Can Expire

Make sure you know the option expiration date.

If you still work for your employer, your incentive stock options that you haven’t exercised will expire 10 years from the date of grant unless the company decides on a shorter period. The issue of shortening the expiration date of options don’t come up often, however, as more companies are trying to stay private longer. When your ISO expires, unused stock options are absorbed by the company.

#8 You’ll Get These Tax Forms If You Have ISOs

When your compensation includes ISOs, you will get several tax forms from your employer or brokerage firm.

Form 3921

Every time an employee exercises an ISO, the employer will file Form 3921 Exercise of an Incentive Stock Option to the IRS. This form contains information about your ISOs such as exercise price, grant date, and exercise date. You should receive it on the year you exercised the option. You will need this form when your tax return in the year when you sell the shares purchased using the ISO.

Form 3922

If you exercised your ISO but decided to hold the stock, your employer will not include it as ordinary income on Form W-2 because you did not sell the shares yet. For these stocks, your employer should issue Form 3922 Transfer of Stock Acquired Through An Employee Stock Purchase Plan. Similar to Form 3921, this becomes relevant when you sell your stocks.

Form 1099-B

Form 1099-B Proceeds from Broker and Barter Exchange Transaction reports any capital gains or losses from selling stock units. Your brokerage should issue this form to you at the end of the year you sold the stocks.

You should always review this form since most ISO tax mistakes happen because the cost basis is incorrect. You may need to make a tax adjustment if the cost basis on your 1099-B does not match your correct adjusted cost basis.

Form W-2

Your compensation income in the current year including the short term capital gains from the sale of ISO shares if you made a disqualifying disposition is reported in Form W-2. This form includes transactions related to employee stock options in Boxes 12 and 14.

Expert Tax Advice Recommended

When exercising ISOs, you always have to be cautious as your actions may trigger unexpected taxes and even the Alternative Minimum Tax.

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