Stock options are one of the most enticing reasons to join an early-stage startup or other growing business. You’re almost certainly familiar with the tales of Silicon Valley employees who “got in early” at startups that went on to incredible valuations and, eventually, extremely lucrative IPOs.
Many people jump at the chance to take a job when they hear their compensation will include stock options. However, if you’re about to receive incentive stock options from an employer, you should know that capitalizing on them isn’t as simple as it might seem.
If fact, if you go in blind, your stock options could actually wind up burdening you with an excessive tax bill. We put together a handy tax strategy guide for anyone with employer-issued incentive stock options.
Here’s what you should know:
What are Incentive Stock Options?
An Incentive Stock Option (ISO) gives you, the employee, the right to buy shares of company stock. In addition, ISOs are potentially entitled to preferential federal tax treatment. It can be a sweet deal—if you make sure you understand the regulations involved and meet their requirements.
There are two main benefits to ISOs.
The first has to do with what’s known as the “spread.” When you’re given an ISO, it comes with a “strike price.” For simplicity’s sake, let’s say it’s $10. This price is often approximately the price at which the shares are valued when the ISO is issued.
However, you may exercise your right to buy that stock at a later date, when the stock is valued higher—let’s say at $20. But because you were issued an ISO with a strike price of $10, you’re able to purchase that stock for $10 a piece, rather than the newer, higher value. Your spread is the difference between the strike price and the fair market value when you exercise your options.
The second tax benefit of an ISO occurs when you decide to sell. If the value of the stock makes it to $30 and you decide that now is the time to sell the stock you exercised your right to buy, then it’s possible that your entire profit will qualify as long-term capital gains. That’s important because long-term capital gains are subject to a lower tax rate than ordinary income or short-term capital gains.
Please note that most employers attach a caveat to their incentive stock options, generally known as a vesting schedule. A vesting schedule usually takes 3-4 years. Each year you stay with the employer, more of your stock option “vests” or becomes available for you to exercise. This is a standard procedure to keep someone from joining a company, receiving an incentive stock option and then immediately leaving to work elsewhere. Be sure you understand how and when your ISO vests when you join a company that offers one.
What Tax Strategy Should I Use With My ISOs?
There are a couple of crucial things to remember when it comes to achieving the long-term capital gains treatment for profits from your ISOs.
- First, the date of sale must be more than two years after the date you were granted the ISO.
- Second, it must be more than a year after you exercised your stock option and purchased your shares.
So, even if you were granted your ISO several years ago, you have to make sure that it’s been more than a year since you actually bought the stock.
This is an important point, especially if you’re considering timing the sale of your stock to make a tidy profit. If you fail to exercise your stock option in a timely manner, you may be forced to sell your stock at a good price but with unfavorable tax treatment.
What About The Alternative Minimum Tax?
The alternative minimum tax (AMT) is designed to ensure that high-income individuals are still paying their fair share of taxes, even though they may have certain preferential tax deductions they can use.
One of the main triggers of the AMT is, as you may have guessed, exercising stock options. The “spread” between the strike price of your ISO and the fair market value at the time you exercised your options can trigger the AMT, if it reaches a certain amount. Though you haven’t actually made a profit on the stock yet, you may have a large on-paper gain.
One way to avoid this situation is simply by exercising your stock options early, before the fair market value increases by a large amount. Of course, this means you’re also betting that it will actually increase. In addition, not everyone has the cash on hand to exercise their options as soon as they can.
If you need help with your taxes, contact AG Fintax today and let our seasoned tax pros take care of it for you!