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Incentive Stock Options 101

Incentive Stock Options 101

March 14, 2022
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Have you ever wondered, my company is growing fast, and the stock price has been increasing, but my salary stays the same unless I receive a promotion? How can I benefit or be compensated with the company improvement as a loyal employee?

Well, your company probably value you as well, so they might already give you a package called Employee Stock Options to reward you for your contribution as depicted in last week’s article. Since there are two types of Employee Stock Options we discussed briefly there – incentive stock options and non-qualified stock options, let us focus on the Incentive Stock Options (ISOs) today.

What are ISOs?

It is a specific type of employee stock option that allows you the right to purchase shares of stock at a predetermined price at some point in the future.

How do you receive ISOs?

You will be awarded and required to sign an acceptance form to officially accept the option grant. Many elements that will impact your ISOs will be provided in a combination of documents including the plan documents, the plan prospectus, and your specific stock grant details. It may be wise to obtain this information from your HR department, as company plan rules can differ.

 

What is included in an ISO grant?

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What is the process/ways for exercising your incentive stock options?

After your ISOs have vested, you can pay cash up front to purchase them. For example, if you were granted 1000 options at an exercise price of $10 / share, once vested, you could purchase the 1000 shares of stock for $10,000 ($1,000 * $10 = $10,000). While this is a large sum of cash, it can be beneficial if you plan to hold the shares for a long period of time to take advantage of certain tax benefits and hoped for stock price increases.

You can immediately sell your vested shares as soon as they are exercised, using the profits to pay for the option costs, and potential taxes, keeping the remainder in a cashless transaction.

Or you can sell enough of the ISOs to pay for the cost of exercising the options, converting the remaining ISOs into shares of stock, and holding the stock until a future date. Assuming the company stock has increase in value since your ISOs were awarded, you can sell a portion and take the profits to pay for the remaining shares. For example, by selling 100 shares at $100 each, you will receive $10,000 enough funds to pay for all 1000 shares. After selling the 100 shares, you will own the 900 remaining shares.

 

When should I exercise my ISOs?

It really depends on your short-term and long-term financial goals, cash position, tax situation, need for immediate income, etc. This is an important decision and often worth consulting an investment professional to determine the best approach for your situation. Here are some scenarios we can play with to have a better understanding of ISOs exercise timing:

  • AN IMPORTANT RULE: you are only eligible to exercise your ISOs after they have vested. Fortunately, you are allowed to exercise the options as soon as they vest in most circumstances. In our earlier example, where 1000 ISOs vested 20% / year over 5 years, after year 1, you would be eligible to exercise 200 ISOs (1000 * 20% = 200).
  • If the company’s stock has gone up since you were granted the ISOs, it may make good sense to exercise the vested options, selling the shares in a cashless transaction and receiving the profits.
  • Or, you have strong faith in the company stocks, which you believe it will continue to go up, you can consider waiting for a period before exercising your ISOs.
  • You may want to think about these before you make the decision though: whether you need the funds in the near term, whether you are concerned for the long-term health of the economy, general stock market trends, prospects of the company, etc.  
  • If you are viewed as a company insider, which is an execution with knowledge of the company’s strategic plans or potential future earnings, you may only be able to exercise options (or sell common stock) during a trading window, typically in the middle of a given fiscal quarter. If you know you are an insider or think you may be, you may want to consult your legal department before you do anything with your options. This helps protect other shareholders who invest in the company but do not have access to the same level of information as company insiders.


What are the tax implications of ISOs?

There are two primary possible tax treatments, called qualifying distributions and disqualifying distributions.

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As a result, your entire profit from the transaction in a qualifying distribution is taxed at long-term capital gains rates, 0%, 15% or 20%, rather than as ordinary income, likely a higher rate. (Higher income earners may also owe the 3.8% Medicare surtax on the net investment income). On the other hand, in a disqualifying distribution, the profit is treated as income for alternative minimum tax (AMT) purposes when you exercise your ISOs. This could trigger having to paying the AMT in that tax year.

It’s helpful to be familiar with the various tax forms that are commonly associated with incentive stock options. For example, ISOs are reported on Form 1040. You may have ordinary income, capital gains (or losses), or both, which will be reported on your 1040 tax return.

Your Form W-2 will include any compensation income received from your employer shown on your W-2, including your income from ISOs upon selling your stock.

You will receive a Form 1099-B the year you sell your ISO stock shares. It reports capital gain or loss on your tax return.

Your employers will also provide a Form 3921 (Exercise of Incentive Stock Options) for the year you exercise ISOs. Information on the form will help you determine AMT, if applicable.

In the event you are required to pay the Alternative Minimum Tax from profits from selling ISO shares, you will need to file Form 6251 (Alternative Minimum Tax), which you use to report AMT from the exercise of incentive stock options.

If you have a financial advisor or tax accountant, they will be very familiar with these forms and can help you properly prepare your filings.