What You Need To Know About Incentive Stock Options (ISOs)

Welcome, everyone. My name is Tan and I am an independent CERTIFIED FINANCIAL PLANNER™ practitioner. Today educational video is on incentive stock options (ISOs).

What are incentive stock options
Incentive Stock Options is a form of compensation. It gives you the right to purchase a certain number of shares at an established price. You might get ISOs when a company wants to attract you to work for them. They can also give you ISOs as a form of a bonus or a raise to retain and reward you.

Please note that:
- ISOs have to be vested until you can exercise (buy) the shares.
- They are not worth anything until they are vested.
- They have an expiration date which means if you don’t exercise it before the expiration date, you cannot exercise it anymore.

Vesting schedule
- A typical vesting schedule is four-year vesting schedule with a one-year cliff.
- After the first year, 25% of the shares are vested then the remaining shares vest monthly over the next 36 months.
- You have to stay with the company for at least a year in order to exercise any options.

Grant (the company gives you)
- When you receive ISOs as a grant, they have a specified price per share if you choose to exercise it between the vesting date and the expiration date.
- For example, the company gives you 100 ISOs on 1/1/2019 at $10 per share and they are vested after 4 years which is 1/1/2023. If in 2023, the company’s stock price is $100 per shares, you can exercise the stock at $10 per share and turn around and sell it at $100 per share, giving you $90 per share profit. Anything above $10 per share is profit.
- If the stock price is below $10 per share, it does not make sense to exercise the stock because you are buying it at $10 per share and selling it for less.

Exercise (you buy the shares)
- After you exercise the ISOs, any gain can be short-term or long-term capital gains depending on the holding period.

Sell (you sell the shares)
- You sell the shares in the open market. Gain or loss depends on how much you bought and sold the shares for.

How are ISOs taxed
- ISOs are not taxed when they are exercised. Think of exercise as buy. You don’t pay taxes when you buy stocks in the market. You pay taxes when you sell the shares and have a gain.
- However, the bargain element which is the difference between the exercise price and the fair market value of the shares issued is added back for Alternative Minimum Tax calculation.
- I just lost a majority of the audience watching this video. Don’t worry, I will provide examples and talk about this later in the video.

If they are sold one year after being exercised (bought) and two years from the date they were granted (gave), they will be taxed at long-term capital gains tax rate. This is called a qualifying disposition.

- Here is an example of a qualifying disposition:
Grant date is 1/1/2019
Exercise date is 1/2/2020
Sell date is 1/3/2021

Qualifying disposition, meaning qualifying you from treating the gain as a capital gain.

Disqualifying disposition, meaning disqualifying you from treating the gain as a capital gain.

Normally, capital gains tax rates are lower than ordinary income tax rates.

TurboTax provides 5 really good examples so I am going to summarize it. For more details, you can go to my blog and click on the TurboTax link under references.

Let’s say, the company granted (gave) you 100 shares at $10 per share on January 1, 2019. You exercised those 100 shares on January 2, 2020 at $10 per share, which is $10 X 100 shares = $1,000. The current price of that stock in the open market is $100 per share.

1/1/2019: Granted 100 shares at $10 per share
1/2/2020: Exercised 100 shares at $10 per share
1/2/2020: $10 X 100 shares = $1,000
1/2/2020: Market value is $100 per share

1: You exercised the ISOs and held it. The bargain element which is the difference between the fair market value ($100) and the exercised price ($10), which is $100 - $10 = $90, then $90 X 100 shares = $9,000; $9,000 is added back for Alternative Minimum Tax.

Exercised the ISOs and held it
$100 (Fair Market Value) - $10 (Exercised Price) = $90
$90 X 100 shares = $9,000
$9,000 is added back for Alternative Minimum Tax

2: You exercised the ISOs and sold it right away in the same calendar year. The bargain element of $9,000 ($90 X 100 shares) is wages to you and it’s taxed at ordinary income tax rates.

You exercised the ISOs
Sold in the same calendar year
$9,000 ($90 X 100 shares) is wages

3: You exercised the ISOs and you sold the stock next year. The gain is wages to you and it’s “calculated as the lesser of the bargain element or the actual gain from the sale of the stock (TurboTax).” If you want the lesser amount, it cannot trigger a wash sale rule, a sale to a related party, or a gift to an individual or a charity. “Because this sale did not occur in the same year as the year you exercised the options, you have to make an adjustment for AMT. When you originally purchased the stock, you should have reported an income adjustment for AMT purposes in that year (TurboTax).”

You exercised the ISOs and you sold the stock next year
Wages = Lesser of bargain element or actual gain from the sale

4: You exercised the ISOs and sold it for more than a year from the date you exercised, but less than two years from granted. The bargain element is treated as compensation to you. The gain above the cost basis is long-term capital gain. “Because this sale did not occur in the same year as the year you exercised the options, you have to make an adjustment for AMT. When you originally purchased the stock, you should have reported an income adjustment for AMT purposes in that year (TurboTax).”

Bargain element = compensation income
Gain above the cost basis = long-term capital gain

5: You exercised the ISOs and sold it for more than a year from the date you exercised and more than two years from granted. The bargain element is added back for AMT when you exercised the option. The long-term capital gain is the difference between the exercised price (the price you pay for the stock) and the sold price. “Because this sale did not occur in the same year as the year you exercised the options, you have to make an adjustment for AMT. When you originally purchased the stock, you should have reported an income adjustment for AMT purposes in that year (TurboTax).”

Bargain Element = AMT Adjustment
Sold Price - Exercised Price = Long-Term Capital Gain

Alternative Minimum Tax
- Continuing from our example, the bargain element which is the $9,000 is added back for AMT calculation and you pay the higher of the AMT liability or the regular tax liability.
- What a lot of people do not know is that when you input your data into the tax program, it runs AMT and regular tax. The program then tells you how much you owe by showing you the higher amount of the AMT liability or regular tax liability.
- The bargain element is subject to AMT when you buy and sell the shares, unless you sell the shares in the same calendar year you exercise.
- “You do have to report that bargain element as taxable compensation for Alternative Minimum Tax (AMT) purposes in the year you exercise the options (unless you sell the stock in the same year) (TurboTax). ”

The big mistake
- The biggest mistake I see is clients coming to me because they didn’t know they have to pay the taxes due to exercising the ISOs even though they didn’t sell the stock.
- If you don’t have the money to pay the taxes when it’s due, you are force to sell the shares at a time you might not what to sell it.
-There are 3 really good strategies to solve this tax problem and I’ll only explain it in-person or during an online meeting because it has to be done correctly.

Exercising ISOs = Bargain Element = Alternative Minimum Tax

What you should know about ISOs
- You really should understand your ISOs plan and how it works.
- Last thing you want is assuming you can exercise the shares and sell it for a profit but cannot due to the fine prints or you do it wrong and pay more taxes that could have been avoided.

Risks
- You are exposed to more risks when holding a single company stock compared to a portfolio of investments.
- Should you hold the company stock or sell it? It really depends on what type of investor you are and what is your plan moving forward. What is your outlook on the company? What other assets do you have? Do you have debts? Etc.

Form 3921
- Here is information directly from the IRS website. “After exercising an ISO, you should receive from your employer a Form 3921.pdf, Exercise of an Incentive Stock Option Under Section 422(b). This form will report important dates and values needed to determine the correct amount of capital and ordinary income (if applicable) to be reported on your return.”

Form 3921 has information about your ISO exercises during the prior tax year.

Let’s review the information
With incentive stock options (ISOs):
- No income recognized when option is granted.
- No tax due when option is exercised, unless you are subjected to ATM.
- When exercised, bargain element which is the difference between the option price and the fair market value on the date of exercise is an add back for alternative minimum tax purposes.
- Tax is due when stock is sold. If stock is held at least one year from exercised and sold at least two years after granted, gain is subject to long-term capital gains tax rates. Otherwise, gain is subject to ordinary income tax rates.

Next steps
- Please note that as tax law changes, your tax situation could be different.
- You should understand and know what you have so you can make the most out of it and prevent costly mistakes.
- Read your plan carefully and come up with a game plan.
- If you need help, please reach out so we can build a plan together.

Thank you for watching and happy planning. This is Tan. Your trusted advisor.

References:
TurboTax - https://turbotax.intuit.com/tax-tips/investments-and-taxes/incentive-stock-options/L4azWgfwy
MyStockOptions.com - https://www.mystockoptions.com
Form 3921 - https://www.irs.gov/taxtopics/tc427

Additional Resources:
● Tax Guide and Resources for 2024 (Abstract) - https://tanphan.com/blog/taxguide24
● “Annual Limitations. There is a $100,000 annual limitation on the value of an employee's ISO that may become exercisable for the first time during any calendar year. See IRC § 422(d). This limit is determined based on the FMV of the stock at the time the option is granted and not at the time the option vests. To the extent in which an ISO is exercisable for the first time (first day the FMV exceeds $100,000), the excess amount over $100,000 is treated as a Non-Statutory Option, subject to all employment tax rules governing those options. At the time of exercise, this results in ordinary income to the employee and a wage deduction to the employer. See Treas. Reg. § 1.422-4 for rules related to the $100,000 rule. See IRC § 422(c)(5) for the special rules for a 10% owner.” - https://www.irs.gov/pub/irs-pdf/p5992.pdf

This material is for educational use only and does not constitute tax, legal, or investment advice. Information may be changed or updated without notice. Consult with a licensed professional regarding your personal circumstances.

Please do not excerpt or copy this information without prior consent from TAN Wealth Management.