Incentive Stock Options (ISOs)
Non-Qualified Stock Options (NSOs) & Incentive Stock Options (ISOs) are options to purchase shares of company stock at a certain price for a certain time. Because the purchase is optional, the purchase is naturally made at a discount to the market price.
Not only are you buying the shares at a discount, but you are also given something of value without having to invest any money; as a result, this is leverage too. Being Granted (gifted) options to buy equity in your company is great, but to make the most of the Grant means understanding the tax and investment consequences. This is more complicated for ISOs than NSOs.
We are skipping the general definition list we often do because most terms are self-explanatory, and the rest are better taught by understanding the ISO process. First, let’s look at the life cycle of the ISO.
Life Cycle of the ISO
Now, let’s look at a typical Grant series. This employee was granted shares at the same time each year for four years, and they have a 4-year vesting schedule. And let’s assume a current stock price of $40.
|
Grant ID |
Grant Date |
Type |
Exercise/Strike Price |
Amount |
Vested (4-year) |
Exercised |
|
|
|
|
|
|
|
|
XYZISO1 |
2/14/2018 |
ISO |
$10 |
800 |
800 |
100(just exercised) |
XYZISO2 |
2/14/2019 |
ISO |
$20 |
600 |
450 |
0 |
XYZISO3 |
2/14/2020 |
ISO |
$30 |
400 |
200 |
0 |
XYZISO4 |
2/14/2021 |
ISO |
$40 |
400 |
100 |
0 |
Grant & Exercise
As you can see, 25% of the Granted amount Vest each year, typical for a 4-year schedule. Vesting means the employee can exercise the options if they wish. One way to look at it is they actually own the options at vesting.
,For our example, let’s assume that the employee just recently (January 2023) exercised 100 shares of the 2018 Grant. Since the 2018 Grant was more than 4 years ago, all of the Granted shares have Vested. Exercising means that the employee actually took possession of (bought) the 100 shares of company stock at a price of $10 per share. Given the current market price is $40, this was a great buy! Keep in mind that the employee did have to pay the $10 per share.
The Sale
The nice part about ISOs, compared to NSOs, is there is no tax due at Exercise, only at the Sell. Because of this benefit, the IRS attaches a few more rules around the sale. To get the full advantage of this tax benefit, taxed at long-term capital gains, you have to wait until one year after Grant and two years after Exercise. This is called a Qualified Distribution and looks like this:
As you can see, the time between Grant and Exercise does not matter; it is the time between the sale and Grant and Sell. In our example, the employee just Exercised, so they will have to wait until 2024 to sell for a qualified disposition, even though the Exercise was almost 5 years after Grant.
ISO Taxes Depend On When You Sell
So, what is the difference in taxes between a qualified and disqualifying disposition?
If either of the one-year or two-year rules are not met at the Sell, the Spread between the Grant/Strike price is taxed as ordinary income. So, in our example, it would be $30 ($40-$10), and any gain from the Exercise date and the Sell date would be either short-term or long-term capital gains depending on the timeframe.
If both the one-year and two-year rules are met, and the disposition (a fancy term for exercising and selling) is qualified, there are only long-term capital gains of the difference between the Grant/Strike price and the Selling price. So, if we sold at $50, we would pay a long-term capital gain on the difference between the Grant/Strike price and the Exercise price, $30, and the Exercise price and Selling price, $10.
Here is what it might look like for someone with a 32% federal tax rate (we will ignore state taxes) and a 15% long-term capital gains rate.
Two Types of Gains
|
Grant/Strike Price |
$10 |
|
Number of Options Exercised |
100 |
|
Total Cost |
$1,000 |
|
Market Value @ Exercise Date ($40 x 100) |
$4,000 |
|
Gain from Grant to Exercise |
$3,000 |
|
Market Value @ Sell Date ($50 x 100) |
$5,000 |
|
Gain from Exercise to Sell |
$1,000 |
|
Total Gain |
$4,000 |
If a qualified disposition and everything is at the long-term capital gains rate of 15%
$3,000 (Gain from Grant/Strike price to price at Exercise) x 15% = $450
$1,000 (Gain from price at Exercise to price at Sell) x 15% = $150
Total tax (not counting state) = $600
You might be wondering why, if all the gain is taxed at 15%, why did we break it out. It’s because we wanted to emphasize how the gains are calculated. It is more relevant for a disqualifying distribution and might look something like this:
$3,000 (Gain from the Grant/Strike price to price at Exercise) x 32% = $960
$1,000 (Gain from the price at Exercise to price at Sell) x 15% = $150
Total tax (not counting state) = $1,110
In the above example, it would be unusual to have a long-term capital gains rate of 15% and still have it be a disqualifying disposition. The reason is you need a year from Exercise to Sell, and if you have that, you usually have the 2 years from Grant and Sell. But it is possible, and this helps demonstrate the two different gains to look at — we hope!
With either disposition, note that no taxes are due at Exercise, like with NSOs. With ISOs, it is based on the Sell. The one small exception is there is an AMT (Alternative Minimum Tax) adjustment for ISOs based on the value of the option at Exercise, even if no sale takes place.
As you can see, the tax difference is usually large between the two types of dispositions. If you wanted a very basic rule of thumb, you would most likely pay at least double the amount in taxes with a disqualifying disposition compared to a qualifying.
Reasons You Might Want to do a Disqualifying Disposition
- It’s a low-tax year, and you might have less taxes than if you wait
- A minimum of 2-years from Grant is a long time to have market and company-specific risk
- You already have exposure to your company stock, and you want to reduce your concentration risk
- You might just need the money! Like college tuition or beefing up the emergency fund.
We’re not going to lie; ISOs are complicated. But they are a great asset and worth the time to understand and plan. Take your time and realize it’s worth it in the long term!