If your company’s compensation plan involves issuing incentive stock options (ISOs), you’ve been given a great opportunity to have ownership in your company.
Companies issue various forms of equity compensation including restricted stock units (RSUs), incentive stock options (ISOs), and non-qualified options (NQOs). For early and growth stage companies, ISOs are the most common form of equity compensation. ISOs give you the option to purchase a set quantity of company shares at a predetermined price.
ISOs have a favorable tax treatment on exercise, but understanding your tax obligations and how to minimize your tax burden can be complicated. Before taking any decisions around your ISOs, it’s important to understand the tax consequences and how that impacts potential future profits.
In this article, we discuss:
- How do ISOs Work?
- Receiving your ISOs
- 409A Valuation
- How are ISOs Taxed?
- Alternative Minimum Tax
- Capital Gains Tax
- Early Exercise
- 83(b) Elections
- How a Tax Advisor Can Help
How do ISOs Work?
Incentive stock options give you the option to purchase a set quantity of company shares at a predetermined price.
When you’re given ISOs, you don’t typically receive the shares right away. In most cases there is a waiting period (known as a vesting time period) before you can exercise (buy) the shares of company stock.
Once your options vest, it means you now have the right to buy your stock options. The exercise price (also known as the strike price) and the number of ISOs issued to you are determined by your employer. That exercise cost is based on a 409A ‘fair market valuation’ (FMV) at the time the options were granted to you.
Receiving your ISOs
The day the ISOs are issued to you by your company is known as the grant date. The grant date and the vesting date (the day your vesting schedule begins) aren’t always the same. Typically the vesting date starts on your first day at the company and the grant date may only happen after you’ve been with the company for a certain period of time.
A typical vesting schedule looks like 4-years vesting with a 1-year cliff. After that, it may be quarterly or monthly vesting. This means that none of your options vest during your first year, but on the date of your first anniversary 25% of your options will vest. For example, if you have 1,200 options you would vest 300 of them on your first anniversary. After that, every three months you would vest another 75 options.
409A Valuation
What is a 409A valuation?
The value of your private company’s stock is determined by a third-party appraiser (if your company is public, the value is determined by the stock market FMV). The report the third-party appraiser produces determines what is known as the 409A valuation. 409A valuations are meant to reflect the current value of the company. They are most frequently triggered in four scenarios:
- When a company first issues equity
- After raising a round of venture financing
- Once every 12 months and more often as a company approaches an exit
- After a material event like a large acquisition
Why is this important?
What’s important about the 409A valuation for you, is that the strike price for new options grants are set at the time of the 409A valuation. This impacts the taxes you pay when you exercise your options. You are taxed on the difference between the 409A when you receive the grant and the 409A when you exercise.
To recap:
- Grant Date is the first day your company issues you ISOs.
- Vesting Schedule determines when you have access to the options granted to you. The Vesting Date is the day your vesting ‘clock’ starts counting.
- Exercise Date is the day you convert your options into shares.
- Strike Price is the price per share you must pay to convert the options into shares.
- 409A Valuation is the value of your company’s common stock as determined by a third party appraiser.
How are ISOs Taxed?
The main types of taxes to know when it comes to incentive stock options are the alternative minimum tax and the capital gains tax.
ISO tax implications vary depending on when you exercise your options and how you go about doing it. Generally, the other two popular forms of equity compensation – non-qualified stock options (NSOs) and restricted stock units (RSUs) – are subject to various taxes upon exercise or vesting like income tax, social security, and Medicare tax withholding. ISOs, on the other hand, are not.
There are two potential taxable events for your ISOs:
- When you exercise your options
- When you sell the shares
When you exercise your options, you may be eligible for the alternative minimum tax (AMT). When selling your shares, you could be subject to capital gains tax. The amount of capital gains tax you pay depends on how long you have held your shares. We’ll explain more about those two types of tax next.
Taxes on ISOs
Alternative Minimum Tax
The alternative minimum tax (AMT) ensures that taxpayers pay at least a minimum level of income tax if their earnings are high. If you exercise incentive stock options, the strike price per share (price you pay) may be lower than the 409A valuation. The difference between the two is your profit and is known as the “bargain element.” You pay taxes on this after a certain amount of ‘profit’ – this is the AMT threshold. Anything below that threshold is tax-free. Everything else is subject to the AMT.
Let’s say the 409a valuation is $40 and the strike price is $5. To the IRS you’re making a $35 profit per share. That $35 difference, the bargain element, could potentially be taxed. There is an AMT threshold that needs to be crossed in order for this bargain element to be subjected to the minimum tax. If you are below this income threshold then you do not owe minimum tax on this bargain element, however, there are other tax implications involving AMT basis in the stock options that are impacted.
It’s important to note that the AMT only applies to what’s known as a qualifying disposition. To have a qualifying disposition, you must hold your shares for at least two years from the grant date and one year from the exercise date before selling. If they’re only held for a time period less than that before selling, it’s considered a disqualifying disposition. A disqualifying disposition doesn’t trigger the AMT and you pay regular income tax on the profits. It also impacts your capital gains holding period. Instead of beginning at early exercise, your long term gain clock will start on the ISO’s original vesting date. We explain more about capital gains tax below.
ISOs and Capital Gains Taxes
What are capital gains?
Capital gains are the profits made from selling your shares relative to what you paid for them (or your exercise price). Those profits are then subject to the capital gains tax. There are two types of capital gains:
Short-Term Capital Gains: These gains are from shares owned for less than one year at the time of sale.
Long-Term Capital Gains: To achieve long-term status, shares must be held for at least one year from the date of exercise.
What are the taxes on capital gains?
Short-term capital gains are typically taxed as ordinary income. Long-term capital gains are taxed at a rate of 0%, 15%, or 20% depending on your taxable income and marital status. Long-term capital gains rates are likely the lowest tax on your company shares. In order to maximize the benefits of your ISOs, it’s typically advisable to hold your shares for a year after the exercise date.
Early Exercise
If your employer allows you to exercise early, you have the potential to exercise at a much lower tax rate because the 409A valuation may be equal to or close to the strike price. If you early exercise your options as soon as they’re granted, you likely won’t owe additional taxes (at the time of exercise) because you’re buying them at fair market value (assuming there’s no spread between what the stock is currently worth and how much you paid). You must keep your shares for at least two years after the option grant date and one year after exercising. However, it’s important to note that you can’t predict how the shares will change in value.
If you do early exercise, it is highly recommended that you file an 83(b) election.
What is an 83(b) Election?
83(b) elections make it possible for stockholders to be taxed on the fair market value of their shares at the time when those shares were exercised (typically, a much lower value) rather than when they vest (typically, a much higher value). This 83(b) election must be filed within 30 days of the exercise date in order to qualify for the special tax rate.
How a tax advisor can help you optimize taxes for your ISOs
Dealing with ISOs and their implications for your tax payment is a complicated matter. Utilizing the right tax advisor can make all the difference in helping you understand your unique situation.
A tax advisor can help you:
- Navigate high, medium, and low tax liability scenarios for exercising options
- Determine your AMT break even and how much you pay in AMT. It is not a straightforward formula/calculation.
- File the right paperwork today and in the future for AMT credits over multiple years. If you pay AMT the year you exercise, you might be able to get some of it back the following year.
- Accurately report in year of filing (if this is wrong you will have to file an amendment)
- Defer current year tax deductions to the following year when the liquidity event will take place and will be of greater value to you.
- Achieve tax savings by other means. Gifting stock to family members or donating options to charity prior to the IPO are two methods. Long-term tax savings could be achieved through the creation of a tax-advantaged trust, by transferring company stock to a trust before the market value increases, or creating a donor-advised fund to make tax-advantaged transfers to charities over multiple years.
- Manage the added complexity around cross-state moves, international moves, or any other considerations that may affect your equity and tax situation on top of just “regular” exercising and selling calculations.
- Determine if you may qualify for your equity gains to be tax free if you held shares for over 5 years and they meet specific qualifications