Though you may not realize it, tech employees have wealth-building tools at their fingertips. If used strategically, these tools can help professionals achieve some of their loftiest financial goals. Incentive stock options (ISO) are just one avenue you can take advantage of, however they don’t come without a learning curve and mistakes with ISO disqualifying disposition can be costly.
You may be wondering what incentive stock options are to begin with. They’re an employee benefit that lets professionals buy shares in their company at a fixed price. If your company offers ISO as an employee benefit, you’ll have a strike price (or exercise price) set by the company. To exercise, you buy the stock option at your strike price. You can sell within one year and have your profit taxed as ordinary income, or you can hold for one year or more and have your profit taxed as long-term capital gains.
When dealing with incentive stock options, one thing to beware of is ISO disqualifying disposition, which can make for an unfavorable tax situation.
An ISO disqualifying disposition is a sale or transfer of ISO shares within two years of the grant and/or one year of exercise. This causes the gain on the shares to be treated as ordinary income, which strips holders of the preferential tax treatment that typically comes with ISO.
Let’s delve into ISO disqualifying dispositions so you can plan correctly for your tax payments and get closer to your financial goals.
What causes an ISO disqualifying disposition?
If you sell a share from the exercise incentive stock options within a year of exercising, you have a disqualifying disposition. You can also have a disqualifying disposition if you sell an ISO share within two years from grant.
If this all happens in the same calendar year, you’ll only see an ordinary income tax hit. However, if you exercise in one calendar year and sell in another, without holding for twelve months and a day, you’ll find yourself in a funny situation that results in incurring two types of tax: ordinary tax and alternative minimum tax (AMT).
Why does it happen?
An ISO disqualifying disposition can occur over the span of two calendar years for a multitude of reasons, but some of the more common ones we see are:
- You need to raise cash before the holding periods are met.
- You exercise too close to the end of the year and don’t have enough time to initiate a trade before December 31 due to trading windows.
- The stock price is at your desired exit price, so you sell because the taxes should be secondary to the share price. You want to optimize for taxes, but if the stock is at a record high and you set a target price to sell at, follow through on your plan.
How alternative minimum tax (AMT) comes into play
High-income earners sometimes have to pay the alternative minimum tax (AMT), which is triggered when taxpayers have more income than an exemption amount that is adjusted annually by the IRS to keep pace with inflation.
In calendar year one, you exercise and hold ISO by December 31. You have to recognize an AMT adjustment equal to the fair market value, less the exercise price, times the number of shares. This most likely creates an AMT tax burden that’s payable.
Let’s look at an example. Say you exercise 50,000 shares of ISO on October 1 of calendar year one. The fair market value at exercise per share is $15, and the exercise price per share is $1.50. You have an AMT adjustment of $675,000. In this example, let’s say you generate a $150,000 AMT tax bill. (This number varies from client to client depending on multiple factors, and I chose this number purely for example purposes.)
In calendar year two, you sell before a year of holding the ISO, causing an ISO disqualifying disposition. This causes you to recognize ordinary income on your wages equal to the fair market value, less the exercise price, times the number of shares. Since wages become inflated, this ultimately creates an ordinary income tax limit.
You’re probably thinking “Wait, that isn’t fair.” You’re absolutely right.
That’s why special calculations are used to ensure you aren’t overpaying on your taxes.
The compensation that’s recognized when you sell is calculated instead as the lesser of these two options:
- Fair market value on date of exercise, less the exercise price, times number of shares
- Fair market value on date of sale, less the exercise price, times number of shares
For example, say you exercise 50,000 shares of ISOs on October 1 of calendar year one. The fair market value at exercise per share is $15, and the exercise price per share is $1.50. On February 1 of calendar year two, you sell those ISOs at a fair market value of $12.50 per share. You can calculate the compensation that’s recognized on your taxes in two ways:
- Option 1: $15 – $1.50 = $13.50 * 50,000 = $675,000
- Option 2: $12.50 – $1.50 = $11 * 50,000 = $550,000
Selecting the lesser of these two calculations, you can use the lower compensation method and end up with $550,000.
Because the sale did not occur in the same year you exercised, you have to make an AMT adjustment to accelerate the recovery of the minimum tax credit. The alternative minimum tax adjustment is used to reduce the AMT tax base. When you sell the stock, your adjustment is equal to the AMT adjustment you previously made when you exercised.
Let’s round out this section with one more example. Say in calendar year one, you paid $150,000 in AMT. In calendar year two, you generate $550,000 in ordinary income. You can use your minimum tax credit of $150,000 to offset any ordinary tax liability generated. Here’s what calendar year two can look like in action: You have an effective tax rate of 37%, and $550,000 in wages are generated through the disqualifying disposition. Ordinary taxes on this are $203,500, calculated by multiplying $550,000 by 0.37. Minimum tax credit carryover from calendar year one is $150,000. Ordinary taxes are offset by the minimum tax credit, reducing liability to $53,500.
Time to make more informed choices with ISO disqualifying disposition
Now that you have a better understanding of ISO disqualifying dispositions over the span of two calendar years, I hope you’re able to make more strategic choices to get closer to your financial goals.
Whether or not you have a good grasp of this topic, it’s still critical you work with a tax professional who can cover your blind spots and proactively set you up for financial success. Book a call today to talk to myself or another expert on our team.
