INCENTIVE STOCK OPTIONS (ISOs)

The “strike price,” which is the price set by the employer business, is used to issue, or “grant,” stock options. This might be close to the value placed on the shares at that time.

On the grant day, ISOs are first issued, and on the exercise date, the employee exercises their right to purchase the options. When the options are exercised, the employee has the choice of selling the stock right away or delaying it for a while. For ISOs, the offering period is always 10 years, unlike non-statutory options, after which the options expire.

Before an employee can exercise employee stock options (ESOs), the ESOs often have a vesting schedule that must be met. In some instances, the employee becomes fully vested in all of the options granted to them at that time under the common three-year cliff timeline.

Other firms adopt a graduated vesting schedule, which starts the second year after the grant and enables employees to invest in one-fifth of the options issued each year. In the sixth year following the grant, the employee becomes fully vested in all of the options.

Tip: The employee can frequently use ISOs to buy shares at a discount from the going market rate, resulting in a quick profit.

The employee may “exercise the option” by buying the shares at the strike price after the vesting period has passed. The employee can then sell the shares at its current price and keep the profit that results from the difference between the strike price and the sale price.

There is no assurance that the stock price at the time the options expire will be greater than the strike price. If it’s less, the worker can decide to keep the options until the very last minute in the hopes that the value will increase. The average lifespan of an ISO is ten years.

An ISO issue might also have clawback clauses. For example, if the employee leaves the company for a reason other than death, disability, or retirement, or if the company itself experiences financial difficulties that make it impossible for it to fulfill its obligations under the options, are examples of circumstances that allow the employer to recall the options.

Important: To be eligible for more benevolent tax treatment, ISOs must be held for longer than one year following the date of exercise and two years following the time of award.

Transactions involving incentive stock options can be divided into five separate categories, each of which may be taxed slightly differently.

With an ISO:

• You should use your option to buy the shares and keep them.
• Use your option to buy the shares, then sell them whenever you want during the same calendar year.
• Use your choice to buy the shares and sell them within the following calendar year, but fewer than 12 months after you first purchased them.
• Sell shares no later than one and a half years after the date of acquisition but no later than two years following the date of your initial award.
• Sell the shares at least two years after the grant date and at least one year and a day after you bought them.

There are several tax ramifications for every transaction. The best options are the first and last. The tax treatment of the proceeds depends on when you sell.

Any profit from the sale is considered as a long-term capital gain and is taxed at a lower rate than your regular income if you can wait at least a year and a day after you buy the stocks and at least two years after you were given the opportunity to sell the stocks (as mentioned in item 5 above). (Your profit is the difference between the stock’s market price at sale and the low price you paid for it.)

This is the most advantageous tax treatment because, in contrast to ordinary income tax rates, which may reach as high as 37 percent in 2021, long-term capital gains recognized in 2021 are taxed at a maximum rate of 23.8 percent (or 0 if you fall into the 10 percent or 15 percent income tax brackets).

Sales that fall within these window periods of one and two years are referred to as “qualified dispositions” since they are eligible for advantageous tax treatment.

You do not have to pay taxes on the transaction as ordinary income at your regular tax rate because no remuneration is reported to you on your Form W-2.

The sales are now referred to as “disqualifying dispositions,” and if you sell the shares before they satisfy the requirements for advantageous capital gains treatment, you might have to pay taxes on some of the sale proceeds at your ordinary income tax rate, which could be as high as 37 percent in 2021.

Selling the stock within two years of the “grant date,” also known as the offering date, constitutes a disqualifying disposition.

A disqualifying disposal also occurs if the shares are sold within a year of the “exercise date,” which is the date on which you bought the stock.

The remuneration must be disclosed on your Form W-2 in both circumstances.

The bargain factor, which is the difference between what you paid for the stock and its fair market value on the day you bought it, is the sum that is detailed on your Form W-2. However, if your bargain portion exceeds your actual gain from the sale of the stock, you must declare the difference as compensation. Ordinary income is what is used to tax the reported remuneration.

The capital gains tax rates as of 2021 are 0%, 15%, or 20% depending on the individual filing, respectively. Meanwhile, depending on income, the marginal income tax rates for individual filers range from 10% to 37%.

When you execute incentive stock options, you purchase the shares at a fixed price that may be significantly less than its true market worth. When you obtain a stock option grant or when you exercise that option, you do not need to report income if you have an ISO.

Only when you sell the shares do you need to file a tax return. Additionally, depending on how long you own the stock, that income may be subject to capital gain taxes, which are normally far lower than regular income taxes and range from 0% to 23.80% (for sales in 2021).

Your taxes with ISOs are based on the transaction dates (that is, when you exercise the options to buy the stock and when you sell the stock).

The bargain element is the difference in price between the grant price you pay and the stock’s fair market value on the day you exercise your option to purchase it.

However, there is a catch with incentive stock options: in the year you exercise the options, you must report that bargain portion as taxable remuneration for Alternative Minimum Tax (AMT) reasons (unless you sell the stock in the same year). Later, we’ll go into greater detail regarding the AMT.

Non-qualified stock options require that the price reduction be reported as taxable remuneration in the year that the options are exercised. This tax is then applied at your regular income tax rate, which in 2021 can be anywhere between 10% and 37%.

When exercised, a non-qualified stock option (NSO), a type of ESO, is taxed as ordinary income. Additionally, when NSOs are exercised, a portion of their value can be liable to earned income withholding tax. On the other hand, with ISOs, no reporting is required until the profit is realized.

ISOs are similar to non-statutory options in that there are numerous ways to exercise them. To exercise them, the employee may pay cash up front, engage in a cashless transaction, or use a stock swap. Depending on how soon after the options are exercised the NSOs are sold, the proceeds may be taxed as ordinary income or as a combination of ordinary income and capital gains.

The disadvantage of the ISO for the employee is the increased risk brought about by the waiting period before the options can be sold. Additionally, there is a chance that the selling of ISOs will generate a profit large enough to be subject to the federal alternative minimum tax (AMT). That often only applies to those with extremely high earnings and substantial option awards.

ISOs include a component of discrimination that is separate from taxation. ISOs are typically exclusively available to executives and/or key employees of a firm, unlike most other types of employee stock purchase programs, which must be offered to all employees of a company who meet specific minimal conditions. As contrast to qualified retirement plans, which must be made available to all employees, ISOs can be compared to non-qualified retirement plans, which are also frequently targeted at individuals at the top of the corporate pyramid.

• Execute an early exercise along with filing an 83(b) election
• Exercise and hold for long term capital gains
• Avoid AMT by exercising just enough options
• Exercise your ISOs in January to maximize the amount of time before you must pay Alternative Minimum Tax
• Receive an AMT credit that can be used to lower your future tax bills
• Exercise NSOs to reduce the AMT on the ISOs
• Split your ISO exercise between December and January to significantly lower your yearly AMT liability
• Use the Disqualifying Disposition to pay ordinary income tax instead of AMT
• Purchase stock using an IRA
• Exercise options in a Qualified Small Business
• Reduce Medicare taxes by investing before an exit
• Defer NSO taxes with an 83i
• Use the swap exercise method
• Roll your Capital Gains into an Opportunity Zone Fund
• Shift to a lower state tax jurisdiction (remote or work-from-home flexibility)