Your client was granted incentive stock options (ISOs) by their employer. If your client is like many, the next question could be, "what are my next steps?" The next steps would generally include a brief review of what ISOs are and how they work. We'll address those steps and then identify how to avoid common traps.
Long-Term Capital Gain Taxation
A client's federal tax cost can be almost cut in half when gains are taxed as long-term capital gains instead of compensation income. Gains from the sale of shares acquired through an ISO are capital gains and, as such, are taxed at long-term capital gain rates not to exceed 20%,1 assuming holding period requirements are met. In stark contrast, the bargain element at the exercise of nonqualified stock options (NSOs) is taxed at compensation income tax rates of up to 38%.2
Next, we'll provide a brief overview review of ISOs.
Incentive Stock Options
Incentive Stock Options can only be granted to employees and must comply with specific guidelines established by the Internal Revenue Code (IRC), which gives them preferential tax treatment.
Key terms that apply to ISOs include:
- Grantor—the employer who grants the options on its securities,
- Grantee—the employee who receives the options,
- Exercise price—the amount paid by the grantee to purchase shares under the ISO, and
- Bargain element—the excess of the stock's fair market value (trading price) over the exercise price when the ISO is exercised.
There are no tax consequences when the ISO is granted to your client. In addition and in sharp contrast to nonqualified stock options (NSOs), your client does not recognize compensation income when they exercise ISOs. Gains at the sale of shares acquired through an ISO are taxed as long-term capital gains (not compensation income) if the requisite holding periods are met.
With this brief overview in mind, let's consider the operation of ISOs.
How ISOs Work
The best way to understand the operation of ISOs is to examine them in each stage, from grant to expiration.
- GRANT: ISOs have no employee tax impact at the grant date. This is because they must be granted at the stock's current fair market value or higher and are generally subject to vesting.
- VESTING: Options are not exercisable until they vest. Options can vest 100% when granted (not the norm) or may vest over time. Upon vesting, the employee has the right to exercise the option. However, there is an annual vesting limit; only $100,0003 in ISO value can vest (become exercisable) in a calendar year. "Value" in this context is the fair market value at the grant date.
- EXPIRATION: Generally, a grant of ISOs must expire (or convert to NSOs) at the earliest of three dates:
- Within three months of termination of employment,
- Within one year of death or disability, or
- Within 10 years of the grant date.
- EXERCISE: The ISO can be exercised any time after vesting and prior to expiration. When exercised, the shares are purchased at the exercise price. The employee owns the shares outright after exercise.
- SALE OF THE STOCK: Gain will be taxed as short-term or long-term capital gain, depending upon whether or not the holding period requirements (discussed below) are met. The gain is determined by subtracting the exercise price paid for the shares plus any transaction-related fees from the sales price.
Now that you have a basic understanding of how ISOs work let's identify common ISO traps.
ISO Traps to Avoid
Traps that happen all-too-frequently include:
- Selling the shares too early,
- Failure to plan for the alternative minimum tax,
- Failure to manage the $100K rule, and
- Being blindsided by accelerated vesting.
Selling the Shares Too Early
- Two holding periods must be satisfied to qualify for long-term capital gains treatment. The two holding periods are 1) at least one year after the exercise date and 2) at least two years after the grant date.
- Mistake to avoid—The shares are sold before both holding periods are met. Clients have a tendency to satisfy the "more than one year from exercise" holding period requirement because it's familiar. Unfortunately, there's also a tendency to lose sight of the "two years from grant date" requirement. For example, if the shares are sold more than one year from the exercise date but less than two years from the grant date, long-term capital gain treatment will be lost.
Failure to Plan for the Alternative Minimum Tax (AMT)
- It's not at all uncommon for clients to assume there are no potential federal taxes at the exercise date. Regrettably, that is not always the case.
- The bargain element at the exercise of an ISO is not subject to compensation or capital gain taxes but is potentially subject to a federal tax referred to as the alternative minimum tax.4
- Mistake to Avoid—Do not be blindsided by unanticipated alternative minimum taxes. Consult a credentialed, experienced professional to minimize or avoid an AMT.
Failure to Manage the 100K Rule
- The 100K rule is among the most misunderstood requirements of ISOs. The rule limits how much value can vest per year, not how many shares can be exercised per year.
- Any ISO value that becomes exercisable in excess of the annual limit ($100,000) within a calendar year is taxed as a nonqualified stock option (NSO); long-term capital gains treatment is lost for the bargain element, and the bargain element is taxed as compensation income.
- Mistake to avoid—Do not assume your client can only exercise $100K in ISO value in any one year. Once vested within the 100K annual limit, more than $100k in ISO value can be exercised within a calendar year.
- For example, assume 100K in ISO value vests annually for three years. The entire 300K in vested ISOs can subsequently be sold within one year and still qualify for long-term capital gains treatment, assuming holding period requirements are met.
Accelerated Vesting Mistake
- An acceleration of vesting, as might occur when there is a change in control of the company, can result in the disqualification of the ISO for tax purposes to the extent more than $100k in ISO value becomes exercisable in any one year.
- In such a case, the option may not be lost but could be treated for tax purposes as an NSO.
- Mistake to avoid—Do not assume your client must immediately exercise the NSOs that result from accelerated vesting of ISOs. The option's expiration date may allow the options to be exercised over a period of years to avoid higher marginal income tax rates from "bunching" income into one year.
This article summarizes the ISO approach to equity-based executive compensation. Remember that other equity-based compensation programs can be used to recruit, reward, retain, and retire executives, including nonqualified stock options, restricted stock awards, and restricted stock units.
Savvy financial advisors and planners with executive clients (or a desire to build an executive client-based practice) should develop a competitive edge in knowing how equity-based compensatory programs work and the key traps to avoid. Greene Consulting offers training in a comprehensive suite of equity-based compensation planning strategies. Click here to see these strategies and more.
To learn more about what Greene Consulting has to offer and how we can help you email Rick Swygman at firstname.lastname@example.org to receive more information.
1 The federal long-term capital gain rate ranges from 0% to 20%, depending upon taxable income and filing status. Be aware that a different federal tax, the Net Investment Income Tax, can add another 3.8% in taxes to at least a portion of the gain, depending upon the facts and circumstances for each taxpayer.
2 The maximum federal personal income tax rate is 37% for compensation income. A 1.45% Medicare tax also applies to compensation income. Social security taxes will not apply to clients in the 37% income tax rate bracket because their compensation would have exceeded the maximum compensation level at which Social Security taxes are levied.
3 Any options that vest in excess of the annual limit become "disqualified" and are taxed as nonqualified stock options.
4 The AMT is an alternative tax system aimed at ensuring every taxpayer pays a "minimum" tax even if the taxpayer is entitled to preferential tax treatment such as found in ISOs.