Become a better investor
Lesson in Course: Finance at work (advanced, 6min )
We received incentive stock options as part of our equity compensation. What are they?
Many startups grant equity to employees in the form of stock options. The equity can become extremely valuable if we end up working at the next Facebook or Uber. However, underestimating taxes and not understanding the full value of the equity we hold can result in a smaller payout.
Our stock options are valuable if the current stock price (FMV) is higher than the strike price value of our stock options. This difference is often called a "spread," which increases over time if the company grows in value.
Companies can offer two types of stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). ISOs are popular among most US-based startups and can only be offered to employees. Companies prefer them because of the tax benefits for meeting specific criteria.
The first benefit is that, unlike NSOs, we can usually exercise our ISOs without paying any taxes.
The exception to this benefit is exercising when the current stock price (the FMV) is significantly higher than our strike price, which could trigger alternative minimum tax (AMT).
We consider ISOs qualified when we meet two conditions:
When qualified, we don't pay any income tax on the money we earn from our ISOs from when we exercise or sell. The gains from selling our shares are taxed as long-term capital gains, significantly lower than income tax rates.
Our ISOs convert into NSOs under two circumstances:
The ISOs lose their tax benefits when they turn into NSOs, which means we'll have to pay income taxes when we exercise.
For extra insight, check out the video by expert Mike Zung, CFP® over on the Watch tab!
Having a plan in place to exercise our ISOs with timing ensures we meet the criteria for the tax advantages when we eventually sell our shares. This way, we don't leave any money on the table or lose it to taxes. We can learn more from the lesson about ISO exercise and sales tax.
Also, we can dive deeper into the lesson on AMT and talk to a tax advisor if we think AMT might be an issue.
A type of stock option offered by companies to their employees that have tax benefits when we meet certain criteria