This is the first post in a series on employer stock programs.
A number of our clients work for startups that offer incentive stock options (ISOs) as part of their benefits packages.
If you’re working at a startup (and not a publicly traded company) and have been given a company stock package, they are most likely ISOs.
But how do ISOs work? What does it mean to exercise stock? Will you owe taxes? If you have ISOs, look back at your offer letter to see the details of the number of shares you were granted, the vesting schedule and the exercise price. Now that you have that information, let’s dive into ISOs more deeply.
What Are Incentive Stock Options?
ISOs are granted to employees as a way to attract, retain, and reward. You may receive ISOs when you get hired, or later on as a form of a bonus or raise.
You receive a grant of ISOs with a specified price per share. You can choose to exercise the ISOs at that price once the options have vested. If the market price is higher than the exercise price, you just bought company shares at a discount.
Keep in mind that the shares you receive aren’t worth anything until they are vested. They often vest completely over three to four years. This means that the longer you stay at the company, the more likely you are to have vested shares.
A typical vesting schedule might look like this: four-year vesting schedule with a one-year cliff (meaning 25% of the shares vest after year one), and then the remaining shares vest monthly over the next 36 months. This means you’d have to stay at the company at least one year before you’ll be able to exercise any options.
When is the right time to exercise your options? It’s hard to say, because it depends on many different factors that would specific to your situation. However, the benefit of exercising your shares is that it starts the clock ticking on long-term capital gains. Which brings us to…
How Are ISOs Taxed?
The reason the ISOs are so popular, and are preferred by many employees, is because they offer two major tax benefits:
- They are not taxed when they’re exercised.
- Once exercised, if they are sold one year after being exercised and two years from the date they were granted, they will be taxed at the lower long-term capital gains tax rate.
Considering that the current top tax rate for 2018 is 37% and the capital gains tax rate is either 0%, 15%, or 20%, depending on income and filing status, this can be a big advantage.
Here’s an example: Let’s say you were granted 100 shares at $25 per share on October 31, 2016. You exercised those shares on November 15, 2017, for $2,500 (100 shares x $25 per share) when the market value was $50 per share, or $5,000 (100 shares x $50 per share).
You then held those shares and sold them on December, 1, 2018. Once you sold them one year after exercise and two years after the grant date, this is what’s considered a qualifying disposition. As a result, the difference between the market value and the exercise price, also known as the bargain element, was $2,500 ($5,000 market value – $2,500 exercise price), which will be taxed at the lower long-term capital gain rate. Not too shabby!
What About Alternative Minimum Tax?
Even if you meet all the requirements for the long-term capital gains rate, you could be subject to the Alternative Minimum Tax (AMT). If you’re making six figures, it is possible that you are subject to AMT.
Remember that bargain element of $2,500 in our example (the difference between the exercise price and market value)? Well, that is added back to your AMT calculation and you will have to pay the higher of your regular tax liability or your AMT liability.
Exercising ISOs and selling company shares can complicate your tax situation, especially if you’d be subject to AMT. I recommend talking to a CPA who can run tax projections to determine how much your tax situation would be affected. They can also estimate how much money you should set aside to pay for capital gains taxes.
Risks to Consider
You often have to exercise your options while you’re still an employee, or no later than three months after your employment ends. This forces individuals who are leaving their job, voluntarily or involuntarily, into an unavoidable taxable event.
Even if you’re staying at your company, you still have risks to think about. If you exercise your options and hold them for one year to get the lower taxable gain rate, you are essentially taking a risk that your company’s stock value will actually decrease over that time.
What happens if your company is bought out or merges with another company? What do the terms of the ISO plan state? Do your options continue to vest, or do they expire, worthless?
Also, if your company folds after you’ve exercised your ISOs, then your shares would be worthless and you’d have wasted money by exercising.
How Does This Look in Real Life?
You can’t sell your shares until your company is bought out, acquired, or goes public. That means that these shares aren’t really worth anything currently because you’re not at liberty to sell them. But what happens if the company goes public? Let’s look at an example.
Your offer letter states that you’ll receive 10,000 shares of ISOs with a four-year vesting schedule and one-year cliff at $1 per share. After two years at the company, you decide to leave and exercise your 5,000 vested shares for $5,000 ($1 per share).
You move on with your life and three years later receive a letter in the mail that the company you were working for has been acquired and your shares are valued at $6 each.
You’ll receive a check for $30,000 (you can’t hold the shares them if they’re not a public company). Since you paid $5,000 for these shares that you’ve held more than two years from offer and one year from exercise, you’ll have to pay long-term capital gains on the gain of $25,000. If you’re in the 15% long-term capital gains tax bracket, you’ll want to set aside $3,750 before allocating the rest of the money towards your financial goals.
Get Help Before You Take Action
All of this can get very nuanced and complicated, which is why we recommend discussing this with a qualified financial advisor as well as a tax professional who can help run tax projections for different scenarios. If you are going through any of these issues, or will be in the future, feel free to reach out to us so we can help you navigate your options (pun intended)!