Incentive stock options or ISOs: everything to consider


    They are an important asset for your company. Therefore, your employer may offer you to share ownership in the form of incentive stock options. However, before you can take advantage of your incentive stock options, you must first become familiar with your options.

    Incentive stock options are only granted to employees who then have the right to purchase a certain number of shares in the company at a certain price with favorable tax treatment.

    There are two types of employee stock options: statutory and non-statutory. They can also be referred to as qualified or unqualified. Incentive stock options are required by law (qualified) and differ from non-statutory (unqualified) stock options or NSOs in a number of key respects:

    Here we focus on incentive stock options to examine what employees should consider when deciding how to use them and the details of their preferential taxation.

    Incentive stock options are a used to motivate and retain key employees. Since you need to keep your ISOs for a period of time, the only way to take advantage of these benefits is to stay with your company for the long term. The higher your company’s share price goes, the higher the reward for your stock options. This promotes high productivity among employees in key positions, as they benefit directly from the company’s success.

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    The day your company grants you incentive stock options is known as the grant date. At this point, your ISOs are subject to a vesting plan or waiting period before you acquire ownership. Once your ISOs vest, you have the right (but not the obligation) to purchase a certain number of company shares at the strike price equal to the fixed strike price stated on your ISO grant. You can choose whether or not to exercise your options at any time up to your ISO expiration date. Usually there is a 10 year period to expire.

    In general, if the exercise price of your ISOs is lower than the current market price of your company shares, you should consider exercising your options. That way, you could buy stocks at the lower strike price and in turn sell those stocks in the market to earn the bargain item – the difference between your strike price and the market price.

    If the exercise price exceeds the current market price, it would not make sense to exercise your ISOs as the company’s shares would be cheaper on the stock market. If the strike price never drops below the market price, your ISOs can expire worthless.

    When exercising, you do not always have to buy the shares in cash. You could potentially opt for a share swap – depending on whether your employer offers it – in which you’d swap the company shares you already own in order to get more shares. Here’s an example: You can buy 1,000 shares of the company for $ 20 per share with your acquired ISO. Stocks trade for $ 40 in the market. If you already own 500 company shares, you can exchange those shares (500 shares x $ 40 market price = $ 20,000) for the 1,000 new shares instead of paying $ 20,000 in cash.

    Alternatively, you may be able to borrow the funds needed to run your ISO from your broker and then sell at least some of the stock to cover your expenses. This is known as cashless and while it has its advantages, it also excludes you from the preferential tax treatment discussed below.

    However, you don’t have to exercise your ISOs and sell them right away. You can hold your unexercised options until just about to expire, or you can exercise your ISOs and hold the stock indefinitely, especially if you believe in your company’s future prospects.

    How do you know which option is best or how long to hold on? That often depends on the tax consequences.

    Incentive stock options offer tax benefits, but certain requirements must be met to get the most benefit.

    ISOs are not taxed when granted, transferred, or exercised. Taxes are deferred until stocks are sold, and if you meet certain holding requirements, ISOs are only subject . This is very different from NSOs, which are taxed at income tax rates when exercised and, in turn, with capital gains taxes when selling stocks.

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    After exercising your ISOs and purchasing shares, a waiting period of more than one year from the exercise date and at least two years from the grant date means that you qualify for a “qualified disposal”. This means your transaction will qualify for preferential tax treatment and you will only owe long-term capital gains taxes.

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    Selling your shares before the hold period expires will result in a “disqualifying disposition” and will likely result in you paying normal income taxes on the bargain item as well as short-term capital gains taxes.

    Although you can get cheap capital gains tax treatment at your ISOs, the bargain item earned must be reported as taxable allowance and can trigger . AMT ensures that certain high-income taxpayers pay at least a minimum income tax rate.

    Holding period risk. From a tax point of view, it makes sense to wait until the requirements of the “qualifying order” are met. However, during this time the stock could fall and wipe out the value of your stock option.

    Concentrated stock. Spreads your investments across different asset classes to reduce risk and compensate for volatility. Hence, it is important to make sure that you are not overly exposed to your company’s stocks in order to minimize the risk in your overall portfolio.

    AMT payment. If you trigger AMT, payment can be problematic. You could get stuck paying your AMT tax bill before selling the stock, which means you cannot use the proceeds from the sale to fund your tax payment. It can be a good idea to practice ISOs earlier in the calendar year so that you have time to raise money and manage your AMT commitment.

    Withholding tax. Because there is no tax payable until stocks with ISOs are sold, your employer does not need to withhold taxes on your behalf. It is important to consider tax liability and set aside the funds required to sell your shares.

    Leaving the employer. If you part ways with your employer but have valid ISOs, keep in mind that you typically have three months to practice your ISOs in order to maintain your ISO status. After this time, your ISOs will be converted to NSOs.

    $ 100,000 ISO limit. An employer is limited in the number of ISOs that it can grant to each employee during a calendar year. If the fair market value of the stock exceeds $ 100,000, the options above the limit will be treated as NSOs.

    When you receive ISOs as part of your compensation, the hope is that your company’s share price will rise well above the strike price over time. In this case, exercising your options means being able to sell for a decent profit. However, using your ISOs means facing complex tax scenarios. Hiring qualified tax and financial advisors who can analyze your overall financial condition could help you exercise your ISOs and sell your company’s stock at the most convenient time.


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