An Incentive Stock Option is a type of employee stock option that gives an employee the right to purchase company stock at a certain price.
What are Incentive Stock Options (ISOs)?
An ISO (also called statutory or qualified stock option) is a type of employee stock option that gives an employee the right to purchase company stock at a certain price called the strike price.
ISOs only apply while you are still employed at the company and you will have 90 days to exercise after leaving, any extension of that expiration date will result in your ISOs flipping to NSOs.
ISOs vs NSOs
ISOs are subject to Alternative Minimum Tax (AMT) at exercise, while NSOs are treated as ordinary income. Both ISOs and NSOs are taxed as capital gains (either short or long-term) when they are sold. However, ISOs are taxed based on the difference between their strike price and the eventual sale price while NSOs are taxed between the Fair Market Value at exercise and the eventual sale price.
These differences create two tax advantages for ISOs compared to NSOs. First, they are taxed at the lower AMT rate at exercise. Second, ISOs can apply long term capital gains at the time of sale to a larger taxable spread than NSOs which are required to pay ordinary income rates on the difference between strike price and FMV at the time of exercise.
Due to their favorable tax treatment for most people, the amount of ISOs eligible to vest each year is limited to $100,000. This is calculated by multiplying the number of shares to be vested in any year by the strike price. The rules are especially troublesome for companies who utilize a 1-year cliff on their option grants because the entire first year's worth of shares plus all shares vesting in the 2nd year will apply towards the $100K Limit. This limit causes larger grants to be split into ISOs and NSOs.
The other difference between ISOs and NSOs is that ISOs are only available to current employees of a company. If a company wants to provide options to contractors or advisors that are not direct employees, they are required to be NSOs. In the same vein, any options that are set to expire beyond 90 days from the employee's final day of employment must be converted to NSOs. Many companies will over severance packages that include the option to extend you ISO expiration deadline by flipping the options to NSOs, this is called an NSO extension.
How are ISO Taxed?
ISOs are eligible for special tax treatment. When you exercise a stock option there is a spread between the strike price and the current Fair Market Value (FMV) that is subject to tax. When exercising ISOs you are exempted from paying ordinary income tax on the spread. However, exercising an ISO is subject to Alternative Minimum Tax, which comes into play for wealthier tax payers or when the spread is large. Additionally, AMT will only be a factor for wealthier tax payers or when the spread between the current FMV and the strike price is large (the AMT exemption recently changed due to 2018 Tax Reform). AMT tax won't be assessed until you pay your taxes the following Spring.
You can use ESO's AMT Calculator to determine whether you will owe AMT from your ISO exercise.
If the ISOs are sold during the same tax year as the exercise you will pay ordinary income tax on the spread between the strike price and the actual sale price. This will be a disqualifying disposition and you will no longer be subject to AMT on the spread between the strike price and the FMV. Moreover, you aren't subject to payroll taxes even though you are taxed at the ordinary income rate. If you sell shares resulting from an ISO after the year of exercise but within a year of exercise or within 2 years of the grant, it is also a disqualifying disposition subject to ordinary income tax, but you are still on the hook for AMT in the tax year of the exercise. This is a form of the dreaded Double Taxation.
If you sell ISOs after the tax year of the exercise you will be subject to AMT for the year of the exercise AND be subject gains tax and/or ordinary income tax on the profits from the sale for that subsequent tax year. Those taxes are calculated based on the spread between the final sale price and the strike price and the FMV at the time of exercise even if you have already paid AMT on the spread between the FMV and the strike price. Recovering the AMT via credits on an ordinary income tax return could take a long time.
If shares resulting from an ISO are sold at least 1 year after the exercise and 2 years from the grant date, then the sale qualifies for long-term capital gains treatment on the spread between the strike price and the final sale price. When ISOs are sold in a disqualifying disposition, then ordinary income tax is paid on the spread between the final sale price and the strike price. ISO's are also not subject to medicare and social security taxes. There is no offset for the ordinary income tax gains from selling your ISOs except for the maximum $3000 ($1500 if married filing separately) allowance of capital losses against ordinary income.
If you hold employee stock options or restricted shares in a private company funded by institutional venture capital, feel free to contact us at the Employee Stock Option Fund for ways to reduce stock option taxes or more information on how we can assist you. By doing so, you can not only avoid the risks associated with investing directly in a startup but possibly improve your taxes as well. For specific tax related support related to stock option exercises, please contact Scott Chou.