You’ve been granted Incentive Stock Options (ISOs) from your company. Awesome, right? But before you do anything, know the tax effect of both your actions and inaction.
Timing and taxes can make or break how much you actually pocket and how much you pay to Uncle Sam.
ISOs are seen as a great incentive as you don't pay income taxes for them at grant or exercise.
...but your exercise of those options can leave you with a MASSIVE tax bill due to alternative minimum tax (AMT) rules.
In fact, you may not be able to sell your ISOs, and still owe 6 figures in tax! It doesn't seem like it should even be legal.
If you hold off on exercising and wait, the value of the stock may increase over time (we hope this is the case!) and can cause you to pay more in AMT tax and more in capital gains tax! Your inaction today could cause you to pay more in tax later.
When you exercise and when you sell, should be deliberate and strategic decisions. Knowing the tax effect of each action is critical to avoiding surprise tax bills.
Is this overwhelming? Read up on the tax effect now, so that you have the knowledge of what's to come when you take action!
If you are receiving an ISO stock grant, it's time to have a relationship with a tax preparer that understands the ins and outs of stock options and can help you make an educated decision.
Proactive tax planning leads to tax savings!
Here’s a few things that can help you in your smart-tax decision making.
NOTE: we are covering ISOs in this article. They have a unique tax treatment not applied to NSOs, ESPPS, RSUS, etc.
The three taxes to know about
There are 2, but really 3, taxes that you want to understand and know about when you have ISO stock options.
- Income and payroll taxes - At grant and at exercise of ISO stock options, there is no income tax and no payroll tax due. This is very unique to ISOs and one of the reasons that companies adopt ISO plans. Your ISO stock options will not show up on your paystub or W2.
- Alternative minimum tax- While you may not be subject to income tax, if there is a difference between your grant price and market price on the date of exercise, you may still be paying tax when you file your tax return as this can create a "minimum" tax due for the year.
- Capital gains tax - When you sell your stock, you will pay capital gains tax. If you hold your ISO stock for at least one year after you exercise and two years after the grant date, you will pay long-term capital gains tax on the sale. If you don't meet both those timelines, you will pay short-term capital gains tax, which is the same as your ordinary tax rate.
Definitions and Key Dates
Before we can dive into these tax effects in more detail, let's first outline and define some of the terms you will hear and dates that will factor in both your decision and your tax calculation.
- Grant Price - The price per share that you pay to "exercise" or buy the stock. As this is an incentive, this is generally less or equal to the market value of the stock.
- Market Price - For publicly traded stock, this is easily obtained by looking up stock on the market. Private companies that issue ISO stock options aren't publicly traded yet and determining market price is a little more involved. Valuation or fair market value per share is be determined periodically and typically goes hand in hand with an investor fundraising round or event. Startup companies will do a 409a evaluation when they raise money and apply a market price to the stock on the date of the evaluation. This market price will stay in place until another 409a evaluation, liquidation or IPO event occurs.
- Sales Price - the per share price you sell stock for
- Grant Date - the date when the grant was issued to you
- Vesting Date - the date when you earned the stock option. Your stock option grant will likely have a vesting schedule and not all vest at once. This determines when you "earn" the stock option. For example, let's say you receive a grant and it vests over 4 years with a 12 month cliff. No options vest or are earned until 12 months from the grant date. At the cliff date in this case it's 12 months from grant, 1/4 of the grant options vest and then the remaining 3/4 options vest monthly until the 4 year period ends. Vesting schedules are implemented by companies as an incentive to retain employees over time.
- Exercise Date - the date when you buy or purchase the stock option
- Early Exercise - when you purchase the stock option before it has vested. If you left the company, all unvested stock options would be repurchased by the company.
- Selling Date - the date when you sell the stock
- Unrealized Gain - the increase in value of the stock that you own, but have not yet sold
- Realized Gain - the increase in the value of stock at the date you sell it compared to the price you paid for it
The AMT: What You Need to Know (and Why It Matters)
The biggest creeper evil tax that surprises most is the Alternative Minimum Tax (AMT). AMT is the sneaky tax that you don't know you hate, until it gets applied to you.
If you ask us, we think it's absurd that this can apply. It is one of the few areas of the tax code where you can owe tax on unrealized gains. In some cases, as in many startup companies that don't have publicly traded stock, you are out the cash you paid to exercise the stock and now out the cash you have to pay for AMT tax and you can't even sell your stock yet.
If you don’t know how to navigate this tax trap, you could end up paying ALOT more in taxes than you bargained for.
We are still talking about the AMT tax effect of exercise! We haven't even gotten into the capital gains tax applied when you sell the stock!
How does AMT get applied in your tax return?
Quick Breakdown:
- Ordinary income tax: This is your typical tax calculation on your tax return—income minus deductions equals what you owe.
- AMT: For this calculation, some deductions go away, and “preference items” (like your ISO spread) are added back in. If your tentative minimum tax under AMT is higher than your regular income tax, guess what? You pay the difference as AMT.
Example Time:
Let’s say your regular income tax for the year is $300,000.
- If your tentative minimum tax comes out to $340,000, you’ll owe an extra $40,000 in AMT.
- Now, if the next year your AMT is lower, say $280,000, you can use a portion of that $40,000 AMT credit to offset your regular income tax. But here’s the kicker: if you hold onto the stock for long-term capital gains, you could end up paying taxes twice—once when you exercise and again when you sell.
When does AMT tax not affect your ISO stock options?
If you exercise ISO stock options and sell the shares of stock in the same tax year, there is no alternative minimum tax applied. BUT you will pay short-term capital gains. In some cases, this can make more sense as you will have the cash in hand from the sale of stock in the same year that you owe the tax! With AMT, you have stock in hand and no cash and owe tax.
This is where a CPA who gets stock options can help you avoid stepping on a tax landmine.
Unrealized vs. Realized Gains
The two driving factors in your tax calculations are made from determining your unrealized gain and realized gains.
Market Price - Grant Price = Unrealized Gain and triggers AMT tax if not sold in the same tax year
Sales Price - Grant price = Realized Gain and triggers capital gains tax in the year sold
Short-term vs. Long-term capital gains on ISO stock sales
If you hold stock for a year, you are long-term when you sell, right? Not necessarily. This is only one of the qualifying factors that determines long-term capital gain rates for ISO stock options. To qualify for long-term capital gain rates, the selling date of ISO stock options must be at least one year from the exercise date AND two years from the grant date.
Short-term capital gains rates are the same as ordinary income tax rates.
In the year you sell ISO stock, you may have large realized gains, which can bump you up a tax bracket or two. Long-term capital gains rates for federal taxes are currently 0%, 15% or 20% and which rate applies to you is determined by your adjusted gross income for that tax year.
Note that your state may treat capital gains differently. For instance in California, there is no special rate for long-term capital gains. All realized gains are subject to state income tax rates.
More than taxes should affect your decision to exercise
We will continue to discuss the tax effects below of exercise, timing and selling ISO stock options. But there are other factors that should come into play in your decision making.
- Do you have the cash to exercise the stock options?
- Do you plan to stay at the company for long enough to have vested options?
- Do you believe that the company will succeed?
The risk is that you purchase stock options (and maybe even have to pay some AMT tax on those options) and then the company goes under and you have a loss.
We will continue our discussion below based on you answering yes to all three questions above....you believe the company will succeed, have plans to stay at the company over time, and have the cash on hand to exercise.
When you may want to exercise or early exercise
If your grant price and the market price are the same, lock in that exercise date and avoid AMT tax altogether. Remember AMT only applies when you have an unrealized gain. If grant price = market price, there is no unrealized gain. ...note that if you early exercise, you have 30 days to file a form 83b with the IRS! This can be just as important to file as exercising earlyl.
If the grant price and the market price are close to the same or is very low, lock in your exercise date and exercise. For example, if you have an exercise price of $.05 per stock option and the current value of the stock is $0.06, your cash outlay and unrealized gain is small, even if applied to a large number of stock options. Lock in that exercise date and exercise as the AMT may not even affect your tax return or be minimal.
If your company is expecting to go IPO, be bought out or you expect a surge in market price, you may want to exercise to start the clock ticking on your holding period that qualifies you for long-term capital gains when you can sell.
Why do we keep saying lock in your exercise date? Both your exercise date and your grant date determine whether you pay short-term or long-term capital gains when you sell. Your grant date is fixed and does not move. But your exercise date is determined by your actions.
If you have a grant with a grant price significantly lower than the market price, you will want to know the full tax picture before you exercise. This is the time you call your CPA and do proforma tax return or tax estimate calculation to fully understand your potential AMT tax impact.
If you exercised ISO stock options in the tax year and have a large unrealized gain, you may want to sell those shares before the end of the tax year even if means you pay short-term capital gains. Again, this when your relationship with your tax advisor becomes a huge asset to you in tax planning. If you don't sell, you will want to have cash on hand to pay the tax bill coming your way from AMT.
Why Timing Is Everything
If you are ready to exercise your stock options, we recommend exercising your ISOs in January, February, March...early in the year.
- This gives you more time to sell or hold and to plan for and obtain tax estimates. Exercising in the beginning of a tax year gives you the chance to track the stock’s performance and gives you time to make decisions inside the tax year. If the price climbs, holding for long-term capital gains might be worth it. If it declines, you can sell before the end of the year and potentially avoid a bigger tax hit.
- Flexibility. If the stock price starts declining, the market price still may be higher than your exercise price and selling early might be your best bet to minimize the tax bill even if it means you pay short-term capital gains as a result.
The key is giving yourself enough time in the calendar year to make a smart, well-informed decision. No one can predict stock prices, but at least you’ll have options, pun intended.
Remember, you are not in this alone. This is when a relationship with a CPA or EA that knows stock options is a game changer.
Beware of grants with FMV over $100K in a calendar year
Incentive Stock Options (ISOs) come with a special tax treatment that we have gone into detail discussing in this article. Note that your ISO stock options are also called qualified incentive stock options. If you surpass a $100,000 per calendar year threshold of granted value, it disqualifies them and the overage is treated and taxed differently.
Any options granted in a calendar year with a market value exceeding $100,000 are treated as Non-Qualified Stock Options (NSOs). The $100K limit refers to the fair market value (FMV) of the stock, as determined when the options are granted, not when they are exercised.
Excess amount: Any portion of your ISOs that exceeds this $100K threshold will be treated as NSOs, which means they'll lose the favorable tax treatment and be taxed under the NSO rules. What happens to this excess?
With NSOs, you'll pay ordinary income tax rates on the unrealized gain in the tax year in which you exercise, instead of AMT tax.
Why You Need a CPA or EA Who Understands Stock Options
Here’s the truth: not all tax professionals deal with and understand stock options. They are tricky and each different type of stock option and restricted stock grant carries its own unique tax treatment. We don't mention NQSOs, RSUs or ESPPs in this article, because their tax treatment is completely different!
Here’s why it’s worth finding a pro:
- They know how to navigate the AMT. The AMT is a beast, and understanding how it works with ISOs requires expertise. A qualified CPA or EA can help you strategize to avoid getting slammed by unexpected HUGE tax bills.
- They see the big picture. Beyond just this year’s taxes, a CPA or EA who understands stock options can help you plan for future gains, losses, and how to best take advantage of credits.
- They provide tax advisory services to help you offset gains. A good tax advisor works with you to provide opportunities and tax strategies that you can enact in the tax year where you expect to see large gains and can provide strategies to offset those gains.
Summary
When it comes to exercising ISOs, timing is everything—but so is having the right team in your corner.
A CPA or EA who really gets stock options is your best asset in this scenario. Don’t leave this to chance or guesswork; get a professional who can help you maximize your gains and minimize your tax burden.
The absolute worst phone calls made by tax preparers happen when we see an ISO stock option with HUGE unrealized gains was exercised and not sold in a tax year. Almost always, it comes with a massive surprise tax bill. This is news we never want to deliver.
Talk to your tax professional BEFORE you exercise and if you do exercise, BEFORE the end of the year. Get a tax projection scenario before you act, your future self and your wallet will thank you.
Book a free discovery call today!
