Employee stock options. Part II – Incentive Stock Options

Employee stock options

Incentive Stock Options

In the first part of this topic, I discussed the investment and tax treatment of Non-Qualified Stock Options.  In the second part, we will dive into the specifics of Incentive Stock Options.

Giving Incentive stock options (ISO) is another way for companies to reward and retain their employees. ISO have more favorable tax treatment than NSOs .While similar to them they have few major differences:

  • ISO are only granted to company employees.
  • They can only be vested for up to $100,000 of underlying stock value each year
  • ISO must expire after ten years
  • They are not transferrable
  • Long term capital gain tax is due on the difference between sell price and exercise price under certain conditions. To receive this tax benefit ISO holder has to keep the stock for one year and one day after the exercise date and at least two years and one day from the grant date.
  • If the sale date does not meet  the above requirements, ISO is disqualified as such and treated as NSO. In that case, you will owe ordinary income tax and short / long-term capital gain taxes
  • Options granted to shareholders with 10%, or more ownership must be priced at least at 110% of the Fair Market Value and not be vested for five years from the date of the grant
  • Alternative Minimum Tax is applicable on the difference between market price and exercise price in the year of exercise. You have to report the difference (also known as bargain element) to IRS. This may have an impact on your final tax at the end of the year depending on various other deductions.

 

Tax Considerations

The granting event of ISO does not trigger taxes. Receivers of incentive stock options do not have to pay taxes upon their receipt.

Taxes are not due on the vesting date either. The vesting date opens a window for up to 10 years by you will be allowed to exercise the ISO.

ISO exercise is not a tax event from IRS perspective if you meet the holding period requirements by selling your stock after one year and a day after exercise and two years and a day after the grant date. Depending on when you sell the stock after exercise six main scenarios can occur:

Scenario 1

You exercise your options and keep them. No tax due, however, you will have to make an adjustment for Alternative Minimum Tax for the amount of your bargain element.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at the exercise price of $10. Your tax rate is 25%. On the exercise date, you exercise the options and decide to keep the shares indefinitely. The market price on that day is $15.

You are not required to report any additional ordinary income.

However, you must adjust your AMT for $5,000.

(15 – 10) x 1,000 = $5,000.

 

Scenario 2

You exercise your options and sell them in the same year, less than 12 months from exercise date. This disqualifies your ISO and converts it to NSO. You will have to report ordinary income on your bargain element and short-term capital gain or loss taxes on the difference between the selling price and the market price at exercise date. You do not need to adjust for AMT if you sell your ISO within the same calendar year.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for three months in the same calendar when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe additional $1,250 for taxes on $5,000 of additional income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

No AMT adjustment is due since you sold your shares in the same calendar year.

 

Scenario 3

You exercise your options and sell them in the next year, but less than 12 months from exercise date. Your selling price is less than the market price at exercise. Since you sell less than a year after exercise, your ISO is disqualified. Because your selling price is lower, IRS allows you to adjust your bargain element to the lower price

Example: Let’s assume that you are granted 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for five months until next calendar year when the price drops to $12 and then sell all your shares.

Your original bargain element is $5,000

(15 – 10) x 1,000 = $5,000.

Since the price dropped from $15 to $12, you are allowed to adjust down your bargain element to $2,000 and add it as additional ordinary income.

(12 – 10) x 1,000 = $2,000.

Since your tax rate is 25% you will owe additional $500 for taxes on $2,000 of additional income.

$2,000 x 25% = $500

Your total due to IRS will be $500.

You will also have to report an adjustment of -$3,000 ([12 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to original bargain element of $5,000.

 

Scenario 4

You exercise your options and sell them in the next year, but less than 12 months from exercise date. Your sell price is higher than the market price at exercise. Since you sell less than a year after exercise your ISO is disqualified.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for 11 months in the next year  when the price goes up to $18 and then sell all your shares. Since you sold the shares before the 24-month mark, ISO shares are disqualified.

You are required to report your bargain element of $5,000 as additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe additional $1,250 for taxes on $5,000 of additional income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

 

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to original bargain element of $5,000.

 

Scenario 5

You exercise your options and sell them after one year from exercise date, but less than 24 months from the grant date. Since you sell less than two years after the grant date, your ISO is disqualified.

You will owe ordinary income and long-term capital gain taxes. Your total due to IRS will be $1,700

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for 18 months in the next year  when the price goes up to $18 and then sell all your shares. Since you sold the shares before the 24-month mark, ISO shares are disqualified.

You are required to report your bargain element of $5,000 as additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe additional $1,250 for taxes on $5,000 of additional income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 15% = $450

Your total due to IRS will be $1,700

 

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to original bargain element of $5,000.

 

Scenario 6 

You exercise your options and sell them after one year from exercise date, and after 24 months from the grant date. Since you meet the requirements for ISO, your sale is qualified.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for twelve months after exercise date and 24 months after grant date when the price goes up to $18 and then sell all your shares.

You are allowed to report $8,000 of long term-capital gain.

(18 – 10) x 1,000 = $8,000.

You will also owe $1,250 on your $8,000 of long-term capital gains at either 0, 15% or 20%. Most people will have to pay 15% (See my posting about short and long term capital gains and losses)

$8,000 x 15% = $1,250

Your total due to IRS will be $1,250.

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to original bargain element of $5,000.

 

What can you do to minimize your tax impact?

  1. Meet the holding period requirements for one year after exercise and two years after grant date. This will give you the most favorable tax treatment.
  2. Watch your tax bracket. Your tax rate increases as your income grows. Depending on the vesting and expiry conditions, you may want to consider exercising your options in phases in order to avoid crossing over the higher tax bracket. Keep in mind that tax brackets are adjusted every year for inflation and cost of living.
  3. Use AMT credits when applicable. In the years when you pay AMT, you can rollover the difference between your AMT and regular tax due as a credit for futures years. The caveat is that AMT credit can only be used in the years when you pay regular tax.
  4. You can donate or give as a gift your low-cost base stocks acquired through the exercise of ESO. You have to follow the holding period requirement in order to get most favorable tax treatment.

 

About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.

Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,  ImageCopyright: <a href=’http://www.123rf.com/profile_stanciuc’>stanciuc / 123RF Stock Photo</a>

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