Incentive Stock Options Basics
One of the biggest benefits of being a startup tech employee is stock options.
It makes sense: the better the company does, the more opportunity you have to grow your personal wealth. As someone helping to grow the company, you have skin in the game, so you, the company’s founders, and the investors all get a win-win situation.
And I know the paragraph above makes stock options sound simple, but the truth of the matter is, they’re far from easy to understand. There are so many tax rules at play that exercising stock options, especially Incentive Stock Options (or ISO), can be a total minefield to figure out.
Which is why we continually write so much about Incentive Stock Options basics and all the tax rules around them: to help you better understand what’s going on with tax law, different types of cost basis, and the choices you have for exercising even if you want to leave the company. ????
But we know it’s a lot to wrap your head around, so we’ve put together a starting point that’ll guide you to all the information you need.
Below, you’ll find links to all of our key articles on Incentive Stock Options basis and their related topics. You can read the brief descriptions below each one to get a basic grasp of the concept, or you can click through on the titles of the posts to read each one in-depth.
You’ll notice this guide is ordered in a specific structure: to first give you a basic understanding of ISO and their risks, the tax rules relating to ISO, guidelines on exercising ISO to get the most bang for your buck, and what to do with your ISO when you realize you want to leave your job.
So without further ado, let’s get into it:
An Essential Understanding of Incentive Stock Options Basics
ISO stands for incentive stock options, and is a company benefit that lets employees buy shares in a company at a fixed price.
If you have ISO as one of your employee benefits, you’ll have a strike price (or buy-in 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 one year or more and have your profit taxed as long-term capital gains.
There is a lot more to it than that, but that’s what the rest of the articles below will explain.
Private Company Stock Options: Risk Factors of Each Type of Equity
In this post, you’ll learn how ISO compares to other types of company stock options when it comes to different risk factors. Here are the main risk factors of ISO:
- Cost Risk – This is the price to exercise. (In other words, money you have to spend that you don’t get to spend elsewhere… hence you’re “risking” it.) To calculate this, multiply the number of shares you want to buy by the strike price of the shares.
- Tax Cost Risk – Unlike other types of stock options, ISO aren’t taxed at the ordinary income rate, which could be seen as an advantage. The thing to keep in mind though, is that ISO does carry the risk of triggering the Alternative Minimum Tax, which is something you’ll want to plan around before you exercise.
- Career Risk – For most companies offering ISO, you have to remain an employee to have these options available to you, otherwise you risk losing them. Alternatively, you may be able to convert ISO to NSO, and we’ve got an article on that below.
Alternative Minimum Tax, Minimum Tax Credit, + Other ISO Tax Treatment
The Alternative Minimum Tax was a provision passed by the government in 1969 to make sure wealthy taxpayers would at least have to pay something to the government, instead of using tax law to avoid paying any taxes at all.
It can be an incredibly complicated topic to understand, but it is one of the biggest tax implications of exercising ISO. (Though it doesn’t have to be if you plan your finances properly.)
How Incentive Stock Options and the Alternative Minimum Tax Work
This article talks about the ISO bargain element, which is how much you “make” when you buy shares at a lower strike price than the current market value of your company’s shares. (Current market value – strike price = ISO bargain element.)
It goes over how your taxes are calculated, and gives you a math formula to follow to begin calculating AMT for yourself. I also give a real-life example of calculating AMT from one of my clients.
Incentive Stock Options, AMT, and Cost Basis: What You Need to Know
This article goes a little more in-depth into calculating AMT when you exercise ISO, and helps you understand the two different types of cost basis when making these calculations. (You have to know both your strike price, cost basis, and your fair market value cost basis.)
It helps you wrap your head around the tax implications of ISO, and what happens to your AMT when you sell your shares and get to use the Minimum Tax Credit (MTC).
ISO & AMT Under the New Tax Plan: What You Need to Know
In 2017, a new tax law was passed that affects taxes calculated for years 2018 and onward. These new rules had pretty big implications for tech and startup employees, and mostly for the better.
In the past, AMT amounts weren’t linked to inflation, so more and more people had to pay it every year. It was getting to the point that paying the AMT was basically eliminating the benefits for exercising ISO for everyday employees with ISO benefits.
Now though, you have more breathing room to exercise more ISO before your trigger the AMT, and it’s easier to recoup the minimum tax credit in the years following.
How Does the Minimum Tax Credit Work? (An Easy-Follow Guide on MTC + Incentive Stock Options)
Let’s say you decided to exercise your ISO one year to the point of triggering and paying the AMT. In subsequent years, you can use the minimum tax credit (MTC) generated by that AMT payment to help reduce your taxes, especially in the year you sell the shares you bought with your ISO.
This blog post gives you an easy-to-understand guide on how the minimum tax credit works after you’ve triggered the AMT. I also show you the numbers behind one of my clients using her MTC, and how much she was able to bring her tax bill down with it.
Supplemental Wages & Taxes: How Are Supplemental Wages Taxed?
A supplemental wage is any money you make that isn’t a part of your regular salary. This can be year-end bonuses, sales commissions, or tips.
But in the startup world, supplemental wages also include RSU, and NSO.
Typically, companies practice some withholding on supplemental wages. As a rule of thumb, they withhold 22% on supplemental wages under $1 million, and 37% on supplemental wages over $1 million. You may owe more than this, so you’d have to pay an additional tax amount to the IRS on top of what your company withholds.
But with ISO, there is no statutory holding requirement, so your company may not withhold any of the money you make on them to pay taxes like the AMT for you. This can be a rude awakening at tax time, unless you’re prepared for it.
Guidelines on Exercising ISO
Now that you know the Incentive Stock Options basics, their risks, and the tax laws that affect them… what are the best practices when it comes to actually exercising them and using them to grow wealth?
3 Reasons January Is the Best Month to Exercise ISO
If you have a choice and the time available to plan ahead, January is the best month to exercise ISO.
Why?
When you buy and hold for a one-year period, your ISO shares qualify for the long-term capital gains tax, which is lower than the regular income tax rate. Plus, Exercising in January means you don’t have to pay taxes on that year until April of the next year, so it gives you 14-15 months to prepare for your tax bill.
There are a couple of other reasons exercising in January is advantageous, and this article goes over them.
When Stock Prices Fall: Selling ISO Exercised in January
The article above talked about why it’s best to exercise ISO in January… but what happens when you exercise in January with the plan of holding for a year, and then the stock price falls?
Do you keep holding in hopes the price will swing back up? Do you hold for one year anyway so you can pay long-term capital gains tax which is a lower rate than the tax you’d have to pay if you sold before the one-year mark?
To avoid big financial loss, it’s best to know what your break-even price would be, and selling before the stock dips below this price.
There are a lot of calculations involved, but this article talks about what to do and what to calculate when you notice your stock prices falling after you’ve made an investment in them with your ISO.
Tender Offer for Shares: How to Get the Most Money & Value Out of Your Tender Offer
When your company announces a tender offer, it can be a great opportunity to use your stock options to grow your wealth, without putting yourself out a lot of extra cash. You can do something I call recycling your shares, which is to sell some of your older shares to buy more new ones.
This blog post goes over the strategy I like to use with my clients, which is to buy and sell NSO, and then with the money from the sale of the NSO, to pay their taxes from that sale, and then to buy and hold ISO. (The reasoning here is that NSO are taxed at exercise, and ISO are taxed as long-term capital gains if they’re held more than a year… which is what is most likely to happen in a tender offer where the company hasn’t gone through an IPO yet.)
When to Exercise Stock Options in a Private Company or Startup
This article goes over when to exercise all different types of stock options in a private company or a startup, but the rules of thumb for ISO are this:
- Exercise ISO any time you can avoid the AMT. (Provided you believe in the company & have the cash to spare, of course. Because there are no guarantees the company will actually make it to an IPO.)
- Right before an IPO happens, when you know the IPO is inevitable, exercising in January (if possible) is a great idea.
Incentive Stock Options & Leaving Your Job
One of the reasons companies have ISO as an employee benefit is to incentivize their workers to stay with the company long-term. But with IPOs happening later and later, ISO as a “benefit” has become a burden to employees who want to move forward in their careers.
Should You Do an ISO to NSO Conversion With Your Stock Options?
Many times, after you leave your job, you only have 90 days to exercise your ISO before you lose the options. Unfortunately, for many startup employees, they don’t have the extra cash sitting around to exercise those options and pay the AMT that exercise would trigger.
And because they can’t afford to exercise now, they either have to stay in their jobs and lose out on career development, or say goodbye to the options they worked so hard to build up over the years.
But, since more companies are aware of this and are letting their employees convert their ISO to NSO, this can be an incredible option for you. Some of the tax rules are different for NSO than ISO, yes, but it does ensure that you don’t lose out on all of your potential wealth.
Should You Borrow Money to Exercise Incentive Stock Options?
Giving the predicament above, private lenders have noticed the problem many startup employees face, and have started offering loans to exercise ISO and cover the AMT cost.
In this article I go over the good, the bad, and the ugly of one of these offers for a loan that was presented to one of my clients. I also talk about crunching the numbers to see if a loan like this is a good idea for you. (Hint: It’s my advice to only do this as a last resort, and to try other things like converting ISO to NSO first.)
Creating an Incentive Stock Options Plan: What to Do Now?
Now that you know the Incentive Stock Options basics, it’s a good idea to look at the options you have available from your company and start making a plan to grow your wealth from them as much as possible.
You can create some of your own plans, for sure, but working with a certified financial planner and tax preparer ensures you leave no stone unturned in getting the most bang for your buck and that you time things right.
Book a call with me today, or use the button below to set up an initial consult with someone on our team.
