Become a better investor
Lesson in Course: Finance at work (advanced, 6min )
We're thinking about exercising and selling our ISOs. What should we expect around taxes?
ISOs (incentive stock option) have tax incentives baked in; however, they also have requirements for their tax advantages. If we meet these requirements, our equity is considered a qualified disposition. Failing to meet the requirements results in a disqualification for the incentives. When ISOs are disqualified, they become a disqualified disposition and turn into non-qualified stock options (NSO).
For ISOs to stay qualified, the following requirements must be met for exercise and sale of stock.
Let’s break out a few definitions used in the example below. Let's say we were granted ISOs at a strike price of $30 per share. We forgo early exercise and decide to wait. When we finally decided to exercise our options a year later, the FMV was $50. We ended up selling our shares for $90 each.
In the example above, the graph on the left shows the outcome when we've fulfilled the selling requirements and our ISO is considered a qualified disposition. This means that we've waited a year after exercising to sell and it's also at least 2 years after the grant date. The qualified disposition results in the $60 difference ($90 - $30) between the sale price and the strike price being treated as a long-term capital gain. At a tax rate of 15%, we would be looking at $9 worth of taxes per share sold. Read more about LTCG.
Note, the $20 difference between the FMV of $50 on exercise and our strike price of $30 may trigger AMT. Read more about ISOs and AMT.
What happens if we wait to exercise until we need to sell?
At a liquidity event, we can exercise and sell at the same time so that we don't need to come up with the cash for the exercise cost.
In this case, since we haven’t exercised early and are exercising as we are selling, our ISOs are disqualified (the right figure in the graph above). The $20 ($50 - $30) difference between the FMV and the strike price at the time of exercise is treated as regular income, and the difference between the Sale Price and the FMV of $40 ($90 - $50) is taxed at the short-term capital gain rate. But wait...short-term capital gain is actually the same as regular income tax. We are now looking at $60 taxed as income—this is much more than the $9 owed above.
Alternatively, if we don’t need the cash right away, we can elect to sell at another liquidity event one year from now and our options stay qualified.
The difference between the Sale Price and the FMV on Exercise would be taxed at the long-term capital gains rate. This is even more favorable if the Sale Price increases during that time, and we can sell for more than $90 per share.
Besides the AMT taxes owed on exercise, ISOs are relatively simple when it comes to taxes owed on the sale of stock. It's normally beneficial to early exercise to avoid AMT altogether. However, if we have not exercised already, we should consider exercising some ISOs at least one year before a liquidity event to make sure they stay a qualified disposition in case we need to sell right away.