Companies can offer two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). The equity can become extremely valuable if we end up working at the next Facebook or Uber. However, underestimating taxes and not understanding the full value of the equity we hold can result in a smaller payout.
In our case, we want to receive ISOs if possible. ISOs are popular among most US-based startups and can only be offered to employees. Startups prefer them over NSOs because of the tax benefits to the employee for meeting specific criteria.
What are ISOs?
Incentive stock options have preferred tax treatment compared to non-qualified stock options.
ISOs are also sometimes referred to as statutory stock options by the IRS and receive a tax benefit only if they are a qualified disposition. For our ISOs to be considered qualified, we need to meet both of these conditions:
- Wait at least one year after we exercise before we sell our shares
- Wait at least two years after the grant date before we sell our shares
At any time, if we do not meet both of these conditions, our ISOs are disqualified and will be treated the same way as NSOs.
The ISO tax benefits during a sale
Our stock options are valuable if the current stock price (FMV) is higher than the strike price value of our stock options. This difference is often called a "spread," which increases over time if the company grows in value and is subject to tax.
When we plan to sell our qualified ISOs, the spread is taxed at a long-term capital gains rate instead of at our income tax rate like other compensation. For many people, long-term capital gains rate is 15%.
We can see in the chart above that NSOs or disqualified ISOs are partially taxed at the income tax rate.
For ISOs to be qualified, we need to exercise at least one year before we plan to sell our shares. Exercising allows us to purchase the company stock at the strike price to hold and sell later.
In most cases, exercising an ISO is a nontaxable event unless we've waited too long to exercise. Exercising when the FMV is high and the spread has widened may trigger Alternative Minimum Tax (AMT). AMT is an uncommon tax rule that prevents the rich from using certain loopholes. We'll cover more about AMT in future lessons. In most cases, planning ahead of time will reduce the risk of AMT.
ISOs can lose the preferred tax treatment
Our ISOs convert into NSOs under two circumstances:
- If we don't meet the criteria for ISOs, the ISOs are considered non-qualified
- Following a mandatory ISO split after reaching the $100K ISO limit
We'll cover the $100k ISO limit in detail in a future lesson. For now, we just need to remember the two criteria above to keep ISOs qualified.
Understanding what ISOs are and how to keep them qualified will help us start forming a plan to manage our equity compensation. The next step is to understand the consequences of exercising and when we would plan to exercise. Having a plan in place to exercise our ISOs with timing ensures we meet the criteria for the tax advantages when we eventually sell our shares. We can learn more from the lesson about ISO exercise and sales tax.
For extra insight, check out the video by expert Mike Zung, CFP® over on the Watch tab!