What is an Incentive Stock Option?

Incentive stock options (ISOs) are a type of equity compensation used by companies to reward and retain their employees. ISOs have more favorable tax treatment than non-qualified stock options. While similar to NQSOs, they have a few major differences:

• ISOs are only granted to company employees.
• They can only be vested for up to $100,000 of underlying stock value each year
• ISO must expire after ten years
• They are not transferrable
• Long-term capital gain tax is due on the difference between the selling price and exercise price under certain conditions. To receive this tax benefit, ISO holder has to keep the stock for one year and one day after the exercise date and at least two years and one day from the grant date.
• If the sale date does not meet the above requirements, ISO is disqualified as such and treated as NSO. In that case, you will owe ordinary income tax and short / long-term capital gain taxes
• Options granted to shareholders with 10% or more ownership must be priced at least at 110% of the Fair Market Value and not be vested for five years from the date of the grant.
• Alternative Minimum Tax is applicable on the difference between market price and exercise price in the year of exercise. You have to report the difference (also known as the bargain element) to IRS. This may have an impact on your final tax at the end of the year, depending on various other deductions.

Key dates

if you own ISOs, you need to keep track of these important dates:

Grant Date – the date when the options were awarded to you
Vesting Date – the date from when the options can be exercised
Exercise Date – the date when the options are actually exercised
Expiration Date – the date after which the options can no longer be exercised

Important price levels

In addition, you also need to keep a record of the following prices:

Exercise price or strike price – the value at which you can buy the options
Market price at exercise date – the stock value on the exercise date
Sell price – stock value when held and sold after the exercise date
Bargain element – the difference between market price and exercise price at the time of exercise

Tax Considerations of Incentive Stock Options

The granting event of ISOs does not trigger taxes. Receivers of incentive stock options do not have to pay taxes upon their receipt.

Taxes are not due on the vesting date, either. The vesting date opens a window for up to 10 years by which you will be allowed to exercise the ISO.

ISO exercise is not a tax event from the IRS perspective if you meet the holding period requirements by selling your stock after one year and a day after exercise and two years and a day after the grant date. Depending on when you sell the stock after the exercise date, six main scenarios can occur:

Scenario 1

You exercise your options and keep them. No tax due; however, you will have to make an adjustment for Alternative Minimum Tax for the amount of your bargain element.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at the exercise price of $10. Your tax rate is 25%. On the exercise date, you exercise the options and decide to keep the shares indefinitely. The market price on that day is $15.

You are not required to report any additional ordinary income.

However, you must adjust your AMT for $5,000.

(15 – 10) x 1,000 = $5,000.

Scenario 2

You exercise your options and sell them in the same year, less than 12 months from the exercise date. This disqualifies your ISO and converts it to NSO. You will have to report ordinary income on your bargain element and short-term capital gain or loss taxes on the difference between the selling price and the market price at the exercise date. You do not need to adjust for AMT if you sell your ISO within the same calendar year.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for three months in the same calendar when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

No AMT adjustment is due since you sold your shares in the same calendar year.

Scenario 3

You exercise your options and sell them in the next year, but less than 12 months from the exercise date. Your selling price is less than the market price at exercise. Since you sell less than a year after the exercise, your ISO is disqualified. Because your selling price is lower, IRS allows you to adjust your bargain element to the lower price

Example: Let’s assume that you are granted 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for five months until the next calendar year when the price drops to $12 and then sell all your shares.

Your original bargain element is $5,000

(15 – 10) x 1,000 = $5,000.

Since the price dropped from $15 to $12, you are allowed to adjust down your bargain element to $2,000 and add it as additional ordinary income.

(12 – 10) x 1,000 = $2,000.

Since your tax rate is 25%, you will owe an additional $500 for taxes on $2,000 of extra income.

$2,000 x 25% = $500

Your total due to IRS will be $500.

You will also have to report an adjustment of -$3,000 ([12 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 4

You exercise your options and sell them in the next year, but less than 12 months from the exercise date. Your sell price is higher than the market price at exercise. Since you sell less than a year after exercise, your ISO is disqualified.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for 11 months in the next year…when the price goes up to $18 and then sell all your shares. Since you sold the shares before the 24-month mark, ISO shares are disqualified.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 5

You exercise your options and sell them after one year from the exercise date, but less than 24 months from the grant date. Since you sell less than two years after the grant date, your ISO is disqualified.

You will owe ordinary income and long-term capital gain taxes. Your total due to IRS will be $1,700

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for 18 months in the next year when the price goes up to $18 and then sell all your shares. Since you sold the shares before the 24-month mark, ISO shares are disqualified.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25%, you will owe an additional $1,250 for taxes on $5,000 of extra income.

$5,000 x 25% = $1,250

You will also owe $750 on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 15% = $450

Your total due to IRS will be $1,700

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

Scenario 6 

You exercise your options and sell them after one year from the exercise date, and after 24 months from the grant date. Since you meet the requirements for ISO, your sale is qualified.

Example: Let’s assume that you are granted ISO equal to 1,000 shares at an exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for twelve months after the exercise date and 24 months after the grant date when the price goes up to $18 and then sell all your shares.

You are allowed to report $8,000 of long term capital gain.

(18 – 10) x 1,000 = $8,000.

You will also owe $1,250 on your $8,000 of long-term capital gains at either 0, 15%, or 20%. Most people will have to pay 15% (See my posting about short and long term capital gains and losses)

$8,000 x 15% = $1,250

Your total due to IRS will be $1,250.

You will also have to report an adjustment of $3,000 ([18 – 15] x 1,000) for AMT in the new calendar year. This will “modify” your prior year AMT adjustment, which was equal to the original bargain element of $5,000.

How to minimize the tax impact of Incentive Stock Options?

1. Meet the holding period requirements for one year after exercise and two years after the grant date. This will give you the most favorable tax treatment.
2. Watch your tax bracket. Your tax rate increases as your income grow. Depending on the vesting and expiry conditions, you may want to consider exercising your options in phases to avoid crossing over the higher tax bracket. Keep in mind that tax brackets are adjusted every year for inflation and cost of living.
3. AMT breakeven – you can exercise just the right number of shares to remain below the AMT tax level. Most accounting software will be able to calculate the exact amount.
4. Use AMT credits when applicable. In the years when you pay AMT, you can rollover the difference between your AMT and regular tax due as a credit for futures years. The caveat is that AMT credit can only be used in the years when you pay regular taxes.
5. You can donate or give as a gift your low-cost base stocks acquired through the exercise of ESO. You have to follow the holding period requirement to get the most favorable tax treatment.

What are Non-qualified stock options?

Non-qualified Stock Options (NSOS) are a popular type of Employee Stock Options (ESO) and a favorite tool by employers to reward and retain workers. NSOs are a contract between the employee and the employer giving the employee the right but not the obligation to purchase company stocks at a pre-determined price in a set period.

Non-qualified Stock Options are similar to exchange-traded call options (ETO) in the way they allow their owner to benefit from the rise of the company stock. However, there are significant differences. There is no public market for NSOs. They can be extended for up to 10 years, while most exchange-traded options expire within a year or two. Additionally,  the employer sometimes can change the strike price of the NSOS while this is not possible for ETO.

Another popular equity compensation is an Incentive Stock Option. Click here to learn more about ISOs

Who gets Non-qualified stock options?

Non-qualified stock options are usually granted to company employees, but they can also be given to vendors, clients, and the board of directors. They can be exercised at any time between their vesting date and expiration date. They offer more flexibility than Incentive Stock Options but have less favorable tax treatment. The key requirement set by the IRS for NSOs is that the exercise price can never be less than the fair market value of the stock as of the grant date. While that can be pretty straightforward for publicly traded corporations, there are several valuation caveats for privately held companies.

Keep track of these important dates

If you own Non-qualified Stock Options, you have to be very strategic and keep track of all dates associated with the contract. You should get a copy of your option agreement and read it carefully. The devil is in the details.

The dates you need to remember are:

• Grant Date – the date when the options were awarded to you
• Vesting Date – the date from when the options can be exercised
• Exercise Date – the date when the options are actually exercised
• Expiration Date – the date after which the options can no longer be exercised

In addition, you also need to keep a record of the following prices:

• Exercise price or strike price – the value at which you can buy the options
• Market price at exercise date – the stock value on the exercise date
• Sell price – stock value when held and sold after the exercise date
• Bargain element – the difference between market price and exercise price at the time of exercise

 Taxes for Non-qualified stock options

The granting event of NSO does not trigger taxes. Therefore, receivers of non-qualified stock options do not have to pay taxes upon their receipt.

Taxes are not due on the vesting date either. The vesting date opens a window up to the expiration date by when you will be allowed to exercise the NSO.

NSO exercise is the first tax event from an IRS perspective. Depending on when you sell the stock after exercise three main scenarios can occur:

Scenario 1

You exercise your options and sell them immediately at the market price. You owe taxes on the difference between the market price and exercise price multiplied by the number of shares

Example: Let’s assume that you are granted NSO equal to 1,000 shares at an exercise price of $10. Your tax rate is 25%. On the exercise date, you sell your shares immediately. The market price on that day is $15.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25% you will owe an additional $1,250 for taxes on $5,000 of additional income.

5,000 x 25% = $1,250

Your total due to IRS will be $1,250

Scenario 2

You exercise your options and sell your company share a few months later (but less than 12 months) at the current price on that day.

First, you owe taxes on the difference between the market price and exercise price multiplied by the number of shares. Second, you also owe short-term capital gain taxes on the difference between the selling price and the market price on the exercise date multiplied by the number of shares.

Example: Let’s assume that you are granted NSO equal to 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for three months when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25% you will owe an additional $1,250 for taxes on $5,000 of additional income.

$5,000 x 25% = $1,250

You will also owe $750 dollars on your $3,000 of short-term capital gains at your ordinary income level (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 25% = $750

Your total due to IRS will be $2,000

Scenario 3

You exercise your options and sell your company shares one year later at the current price on that day.

First, you owe taxes on the difference between the market price and exercise price multiplied by the number of shares $5,000 ((15 – 10) x 1,000) as additional ordinary income. Second, you also owe long-term capital gain taxes on the difference between the sale price and the market price on the exercise date multiplied by the number of shares.

Example: Let’s assume that you are granted NSO equal to 1,000 shares at the exercise price of $10. On the exercise date, the market price is $15. You decide to keep the shares for twelve months when the price goes up to $18 and then sell all your shares.

You are required to report your bargain element of $5,000 as an additional ordinary income.

(15 – 10) x 1,000 = $5,000.

Since your tax rate is 25% you will owe an additional $1,250 for taxes on $5,000 of additional income.

$5,000 x 25% = $1,250

You will also owe $450 dollars on your $3,000 of long-term capital gains at either 0, 15% or 20%. Most people will have to pay 15% (See my posting about short and long term capital gains and losses)

(18 – 15) x 1,000 = $3,000

$3,000 x 15% = $450

Your total due to IRS will be $1,700

Tax Impact Summary

• The receiver of non-qualified stock options will pay taxes on the difference between the stock market value and exercise price at the time of NSO exercise. The value has to be reported as an additional ordinary income.
• If stocks are sold immediately after exercise at the current market value, you only owe taxes on the difference between market and exercise value.
• In case you decide to keep the stocks you will owe long-term or short-term capital gains taxes depending on your holding period.
• If the stock goes down after exercise and you choose to sell, you can report a short-term or long-term capital loss. You can use this loss to offset other capital gains. You can also use up to $3,000 of capital losses to offset ordinary income (like salary, commissions, interest). The remainder of the loss in excess of $3,000 can be rolled over in future years.

IRC § 83(b) election

IRC § 83(b) election allows companies to offer an early exercise of stock options. When making this election employees will pay income taxes on the fair value of their stock options. The early election is especially lucrative for founders and employers of early-stage startups with low fair market value.

This election is rarely done due to the difficulty in calculating the value of the options. If you can determine the value at the time of the grant and decide to pursue this road, you will owe taxes on the fair market value of your options at the grant date. But no income tax will be due at the time of vesting. Another disadvantage of this strategy is the risk of the employee stock price falling below the level at the time of the grant. In this scenario, it would have been advantageous to wait until the vesting period.

What can you do to minimize your tax impact?

1. Prioritize long-term vs. short-term holding period. Selling shares after holding them for more than 12 months will trigger long-term capital gains which have favorable tax rates over short-term capital gain rates.
2. Exercise your options as close to the exercise price as possible. However, companies often set very low exercise price, and this strategy may not be viable.
3. Watch your tax bracket. Your tax rate increases as your income grow. Depending on the vesting and expiry conditions, you may want to consider exercising your options in phases to avoid crossing over the higher tax bracket. Keep in mind that tax brackets are adjusted every year for inflation and cost of living.
4. You can also donate or give as a gift your low-cost base stocks acquired through the exercise of NSO
5. If the NSO options are transferable, usually restricted to family members, you can consider giving them away as a donation or a gift