Incentive Stock Options: The Basics

Matt Gray, CFP®

More and more employers are attracting top talent by offering various forms of equity compensation. Incentive Stock Options (ISOs) are a popular choice usually offered by pre-IPO companies and are among the more complex ways to own stock.

ISOs have huge potential benefits but, due to their complexity, also require a strategy to realize the greatest benefit. First, let’s cover some of the basics of ISOs.

What is an Incentive Stock Option (ISO)?

A stock option is an investment vehicle in which the investor has the OPTION to purchase a share of stock at a pre-determined price.

An incentive stock option is a stock option that your employer has paid to you as part of your compensation package. There are tax benefits of this type of option that we’ll discuss in more detail below.
An ISO award might look something like 12,000 shares which you can be purchase at $5/share and you’ll receive the options on a monthly basis over the next four years, otherwise said as 250 shares per month.

How Does an ISO Work? 

There are a few components important to understand how ISOs work.

Grant – The number of stock options you are going to receive and the schedule you will receive them

Vest – The point at which you actually receive the option. You might be granted 100 shares on 1/1/2023 but not have them vest until 1/1/2024.
Strike Price – This is the amount specified at which you can purchase a share of stock once it has vested.

Fair Market Value – The value of the stock at a specified time. Publicly traded stocks are priced live, while private companies use a private valuation often listed as a 409(a) value.

Bargain Element – Also known as a compensatory component, this is the difference between your strike price and the fair market value. This is a key item when it comes to calculating taxes.

An employer grants a number of shares to an employee that has a pre-determined strike price and vesting date. Once the options have vested, the employee normally has ten years to choose if they want to purchase the stock at the strike price. If the employee wants to buy the stock, they must pay the strike price in exchange for the share of stock.

How are ISOs taxed?

This is where things begin to get complicated and are subject to the dreaded answer of “it depends.”

There may not be any tax liability at the time of purchase if the total bargain element is small enough. The shares would be subject to capital gains rates at the time of sale.

But what if the bargain element IS big enough? That’s where the shadow tax code of Alternative Minimum Tax rears its head.

What is Alternative Minimum Tax (AMT)?

Once you get into this territory, it is worth reaching out to a CPA and having someone help you with the details. I did just that and have called on Bruce Gray, a CPA based out of Milliken, CO.

Bruce explains that “The Alternative Minimum Tax, or AMT, is a recalculation of your tax liability that eliminates certain specified tax benefits, or preferences, under the Internal Revenue Code. In the case of ISOs, the bargain element must be determined, and that amount must be added back to income for purposes of calculating AMT. You pay the higher of either the regular tax or the AMT.”

In the standard income tax calculation, the bargain element isn’t considered taxable income. AMT has a separate system of tax brackets that DOES include the bargain element. Each year you purchase stock options through your employer, you need to run both calculations (or better yet, have your CPA do it for you).

The simple calculus for this is the more stock options you decide to purchase or “exercise” each year, the more likely it is that you end up paying AMT.

What is the AMT Credit, and When Does it Apply?

The good news is that you can get some of the AMT paid back in future years through tax credits.

Bruce again stated, “The AMT credit arises when you pay AMT in one tax year on an item that is a timing difference. This means that the overall tax paid over a long period of time will be roughly the same under the two calculations. An item that is a permanent difference will not generate an AMT credit. Examples of timing differences are things like ISOs and depreciation. Over time the overall tax will be close to the same, which is why it is a bit confusing that so many people want to avoid AMT.

Regarding ISOs, the credit applies if you owe AMT in one year and then don’t in the following year. Talk to your CPA about whether it applies to you or not, as the calculation can get rather complex.

In Summary

Figuring out the best way to utilize your ISOs can be harrowing. You receive them at different intervals, you have to pay for them and then MIGHT owe tax, and then you MIGHT owe tax a second time when you sell the underlying shares.

There are some final considerations when dealing with ISOs.

  1. Start early – there are often advantages to begin exercising shares as early as possible.
  2. Have a plan – know how you are going to come up with the funds to exercise and pay potential tax liabilities.
  3. Talk to a tax professional – The tax implications are complex even when you understand them well, so hire a tax professional if you have ISOs to help you avoid any surprises come tax time.

About the Author - Matt Gray is a Childfree Financial Planner who holds both the Certified Financial Planner® designation and the Chartered Advisor of Philanthropy designation. He enjoys working with his Childfree peers because he enjoys helping solve the specific needs of the Childfree community. Furthermore, he believes choosing a less traditional life path leads to more unique life stories and he loves helping those stories become a reality.