Incentive Stock Options – The Basics

Jeff Branson, MBA, CFP® – Jeff is the founder of Branson Financial Planning. He spends his time acting as a personal CFO to households across the United States. He believes that financial advice should be clear, objective, and delivered in a fiduciary manner. When he’s not working, Jeff spends time exploring beautiful Maine with his girlfriend Bianca and his golden retriever Mavrick.

Stock options come in two different forms: non-qualified (NQSO) and qualified (incentive stock options – ISO). This page explains the key basic concepts of ISOs. An ISO gives you the right to purchase a company’s stock for a predetermined price. Incentive Stock Options can get INCREDIBLY complex when planning their eventual exercise and sale. This page won’t go over every detail or strategy surrounding options. This is just for the basics. Let’s run through a fictional scenario to highlight the key areas to understand:

You are awarded 100 ISOs on Jan 1, 2021 with an exercise price of $10. You have been given the OPTION to purchase your company’s 100 awarded shares at $10 per share. Put simply, you have the OPTION to spend $1,000 ($10 x 100) to acquire 100 shares of your company’s stock. If the company’s current fair market value (FMV) of the stock is trading at $50, you would realize a $40 per share gross profit ($50 FMV – $10 option) if you were to sell your shares the same day. This is how an ISO works in its most basic form.

Grant Date: This is the date you are awarded options. Upon grant, your company will have you sign a grant agreement specifying all the details of the options awarded to you. At this point, it would be wise to read carefully through the agreement and to save a copy for your own records. This is NOT a taxable event.

Strike or Exercise Price: This is the predetermined price that you can purchase your company’s stock. A strike price that is above the FMV of the underlying stock is considered ‘under water’.

Vesting: Most companies do not allow you to exercise your options immediately upon award. Companies will attach a vesting schedule to the awards to retain talent over periods of time. Your options are essentially restricted from exercising until the option vests. An example vesting schedule:

-25% of the awards on the Jan 1, 2022

-75% over the remaining 15 calendar months

This means you will only be allowed to exercise 25 awards (25% of 100) on January 1, 2022 or later. 5 options will vest on Feb 1, 2022, 5 more on March 1, 2022, etc. This will continue until all the options vest or the options expire.

Expiration: Unfortunately, your options can lapse and become worthless under several circumstances. Companies set a time limit from the grant date to exercise the option. This time limit is typically 10 years from the grant date. If you quit your job, die, or become disabled, that time limit can be much shorter! Companies can also throw in other anti-competition clauses should you go to work for a direct competitor. It’s key to know when your options expire upon certain life events. It’s common for individuals to think their 10-year time limit carries over when switching jobs. The expiration date typically gets changed to 60 or 90 days from the day you leave. Much shorter than 10 years from grant!

Bargain Element: The bargain element is the difference between the strike price of an option and the underlying stock’s FMV. This is an ESPECIALLY important concept to understand as it pertains to taxes. The bargain element at exercise is either a tax preference item for the AMT OR taxed as ordinary income. How the bargain element is taxed will depend on when you disposed of your ISO shares (more on that shortly).

Alternative Minimum Tax (AMT): AMT is exactly as it sounds: an alternative way to calculate your federal income tax that produces a minimum tax. It is NOT a double tax, as many seem to believe. For the sake of keeping this ‘basics’ article…basic, I’ll sum up AMT by saying that you must pay the greater of AMT or your regular taxable income. If your AMT is greater than your regular taxable income, you pay the difference and enter this on your 1040 – Schedule 2. The good news is that you are eligible for a tax credit in later years based on the amount you paid in AMT.

Your AMT is calculated differently from your regular tax. There’s wiggle room (usually) to exercise enough ISOs to keep you under the AMT apron. This makes planning much easier and straightforward if your regular income tax is greater than your AMT. This sometimes isn’t the case with a quickly rising stock price or blackout periods restricting your ability to exercise. Timing your option exercise is imperative.

Exercise: Exercising is the action of purchasing your options. There are a few different ways to exercise your ISOs:

-Cash: You pay cash to exercise your shares.

-Cashless or same day sale: You sell enough of your options the same day you exercise to cover your exercise price. For example, you have 100 options at $20 exercise price when the FMV is $50. Instead of paying $2,000 out of pocket, you sell 40 shares ($2,000 total exercise price / $50 FMV) to pay for your exercise. No cash needed at exercise!

-Stock Swap: You swap enough currently owed shares at FMV to cover the exercise price.  

I’ll say again: the timing of when you exercise your ISOs is crucial. If you exercise your ISOs and you don’t dispose of them in the same year, the bargain element will be subjected to AMT. Exercising too many shares can put you in a pinch come tax time when trying to budget for an unexpected tax bill because of ‘phantom’ income the ISOs produced. Careful planning is a must.

Sale and Qualifying vs Disqualifying Disposition: How your ISO shares are taxed will depend on when your shares were disposed (sold, transferred, donated). ISOs are only tax qualified if you hold onto your shares more than two years from the grant date and one year from the exercise date. Doing so makes their disposal a QUALifying disposition. If you sell, transfer, or donate your ISOs before those two dates, you are no longer eligible for the favorable tax rules ISOs are eligible for.

A DISqualifying disposition occurs in all situations where your shares were not disposed of in a qualifying disposition. When this occurs, your bargain element is taxed as ordinary income (although not subject to FICA).

Double Basis: The situation gets a little tricky when you exercise your shares (and subject yourself to AMT) in one year but wait to sell them in a later year. In this situation when you’re ready to sell your shares, you must calculate the basis of our ISO shares differently for regular tax purposes and AMT purposes. For regular tax, your basis is your strike price and for AMT your basis is the FMV at exercise. Any differences between the AMT gain/loss and the regular gain/loss are reported as AMT adjustments.

Calculating the AMT adjustment is especially important. At this point, you might think you’re being taxed twice: once by regular tax and again by AMT. This isn’t quite the case. The AMT tax you paid is recouped through the credit in later years and is accelerated by AMT adjustments through the disposition (selling) of your ISOs.

The details of the double basis and the AMT credit are beyond this basics article but are well worth being aware when you dispose of your shares.

Final Words: I hope my example made this concept simple and easy to understand. ISOs and their tax implications are not easy to grasp. The biggest decisions you need to make with ISOs are: 1) when to exercise and 2) when to sell. Unfortunately, there’s no one right answer as everyone’s goals and situations varies. Knowing the basics will at least give you the idea of what happens during the exercise and sell events.

As always, remember to consult with your tax, legal, and investment professionals.