Incentive stock options, or ISOs, are a pretty common way for companies to compensate management and key employees.  Otherwise known as “statutory” or “qualified” options, ISOs are a way to give management a stake in the company’s performance without doling out a bunch of cash.

While they can have wonderful tax benefits, far too many people who own ISOs fail to exercise them wisely.  Some estimates even claim that up to 10% of in the money ISOs expire worthless every single year.  If you own incentive stock options but aren’t sure how to manage them, read on.  This post will cover a few of the top management strategies at your disposal.

 

What are Incentive Stock Options?

In many ways, ISOs are just like any other stock option.  The owner of the option has the right to buy a certain number of shares for a certain price for a certain amount of time.  As the name implies, incentive stock options are usually used to compensate upper management & key employees.

ISOs are issued on a grant date, at an exercise price that’s usually below the current value of the company’s shares.

In most circumstances a vesting schedule applies.  Even after ISOs are issued, recipients can’t exercise the options until they’ve become vested.  This could be a graded schedule, where a certain percentage vests each year, or a cliff schedule where they all vest at once.  Once vested ISOs usually have an offering period of ten years, after which they’ll expire.

Benefits of Incentive Stock Options

The main advantage of incentive stock options is their favorable tax treatment.  Neither the grant or exercise of incentive stock options is considered a taxable event.  Instead, tax is only reported once the shares are sold.  The tax treatment depends on whether the transaction was considered a qualifying disposition or a disqualifying disposition:

Qualifying Dispositions

Sales of ISO shares are considered qualified if they’re made at least two years after grant date, and one year after exercise.  In a qualifying disposition, the bargain element (sale price – exercise price) is taxed at long term capital gains rates.  This can be a huge savings, since long term capital gains are currently taxed very favorably.

Disqualifying Dispositions

Anything that’s not considered a qualifying disposition is a disqualifying disposition.  The bargain element in disqualifying dispositions is taxed as ordinary W-2 income.  Additionally, companies aren’t require to withhold taxes from disqualifying dispositions.  Since they’ll be counted as income, that means you could owe income, Social Security, FUTA, and Medicare tax out of your own pocket.

Here’s an Example

Mary get an offer to become the CFO of a tech startup.  Part of her compensation is 10,000 incentive stock options subject to a 3 year cliff vesting schedule.  The startup recently had their company valued at $25 per share, and the exercise price on Mary’s ISOs is $15.

Three years into her tenure as CFO, the ISOs vest and the shares are valued at $50 each.  Mary decides to exercise all of them.  She also wants to buy a new house, so she decides to sell half of the shares resulting from the exercise immediately.  Mary sells the other 5000 ISOs 18 months later, when the company is trading at $60 per share.

Mary’s first sale is a disqualifying disposition, since she held the shares for less than one year after exercise.  That means that she’ll need to report the bargain element ($50 – $15 = $35) of each share as W-2 income.  This comes out to $35 * 5,000 = $175,000.

Her second sale 18 months later is a qualifying disposition: the sale occurred more than two years after it was granted, and one year after it was exercised.  The bargain element of this transaction ($60 – $15 = $45 per share) is taxed as a long term capital gain: $45 * 5,000 = $225,000.

Also, Mary would need to come up with enough cash to buy the 5,000 shares she didn’t immediately sell.  At $15 per share, this would be $15 * 5,000 = $75,000.  She could use some of the $175,000 from the immediate sale though, of course.

Alternative Minimum Tax

The tricky part about qualifying dispositions of ISOs is that the bargain element is a tax preference item for AMT purposes.  That means that sizable qualifying dispositions could push you into a situation where you’re subject to the alternative minimum tax.  There are many other factors that go into the AMT calculations though, making each situation unique.  As a general guideline, minimizing your tax burden will mean you try to avoid the alternative minimum tax.

 

Strategies for Managing Incentive Stock Options

There are a couple different ways to go about managing incentive stock options.  The right strategy for you will depend on your financial position, the confidence you have in your company, and how comfortable you are having a concentrated position in your company’s stock.  Here are the basics:

Cash Exercise

Remember that when you exercise your options, you’ll be buying shares of stock at a specified price.  That means that you’ll need to put up cash.  It might be painful to reach into your own pocket when exercising ISOs, but most of the time you’ll need to in order for the entire transaction to be a qualifying disposition.

So, if you want to avoid income tax you’ll need to wait at least a year before dumping the shares.  That could be a little dangerous if your company is unstable – moreso if the stock comprises a large portion of your net worth.  If you’re uncomfortable going out of pocket to take this risk, a cashless exercise might be more suitable.

Cashless Exercise

In a cashless exercise you don’t have to go out of pocket at all.  Your shares are sold immediately at market prices, and you simply receive the bargain element in cash: the difference between the market and exercise prices.

Cashless exercises are disqualifying dispositions though, since you’re only holding the shares for a very short time.  That means that the cash you receive will be counted as income.

Cashless Hold

Rather than immediately sell all the exercised shares in a cashless exercised, you could always sell just enough to cover the exercise.

Here’s an example.  Let’s say Mary (from our example above) wants to exercise all 10,000 of her ISOs once they vest, but doesn’t want to go out of pocket.  The exercise price is $15, meaning she’d need to come up with $150,000 to do so.

Since the stock is currently trading at $50 per share, she could immediately sell 3,000 of her 10,000 shares to cover the cost.  Net result?  She’d be left with 7,000 shares, and $150,000 added to her taxable income.

Stock Swap

If you already hold shares in your company, you could also use a stock swap.  When you exercise, you can surrender existing shares to your company at current prices to fund the exercise.

In Mary’s example, she’d need to put up $150,000 in order to exercise her ISOs.  If she already held shares in the company, she could surrender 3,000 of them ($50 * 3,000 = $150,000) to fund the purchase.

Stock swaps are tax deferred transactions.  Any basis you have in existing shares is carried over to the new shares you’ll receive.  This can be pretty helpful.  It allows you to avoid realizing taxable gains on old shares when your objective is to raise cash to buy new shares.

Disqualifying Disposition

With most ISO strategies we’re assuming that an option is in the money.  In other words, the market price of the shares is higher than the exercise price on the options you hold.  In this circumstance the best way to limit taxes is to make sure any transactions are qualifying dispositions.

This isn’t always the case though.  If your company runs into trouble there’s always a chance that the market price is lower than the exercise price on your options.  Many people in this situation assume that if their options are out of the money, their only choice is to let them expire worthless.

Why not pursue a disqualifying disposition?  By selling the shares before the holding period requirement for a qualifying disposition, the bargain element (stock price – exercise price) is treated as income.  If the stock is trading lower than its exercise price, the bargain element is negative, and can work to offset income.

Incentive Stock Options & Tax Management

At the end of the day, like anything, the right strategy for you should align with your comprehensive financial strategy.  ISOs can have great tax benefits, but in order to qualify you’ll have to hang on to the shares for at least a year.  Make sure you’re comfortable with this type of concentration risk, understand the tax implications of both qualifying and disqualifying dispositions.  Thousands of “paper millionaires” have been wiped out after being too confident in the future value of their company’s shares.