Incentive Stock Options (ISOs)

Key Terms:

​

• Grant Date: The date the ISOs are issued to an employee.

• Strike Price: The price at which the employee can purchase the company’s stock.

• Vesting Period: The period after which the employee can exercise the option to purchase the stock.

• Exercise Date: The date when the employee exercises the option to purchase the stock.

• Expiration Date: The date after which the option can no longer be exercised.

• Bargain Element: The difference between the strike price and the market value of the stock at the exercise date.

 

By issuing ISOs, companies seek to align the interests of employees and shareholders.  The vesting period associated with ISOs encourages employees to remain with the company.  For startups and growing companies with limited cash flow, ISOs also offer a way to compensate employees without immediate cash outlay.  Employees are incentivized to contribute to the growth of the company and are granted a means to participate in the potentially meaningful financial gains of a liquidity event such as an IPO or acquisition.

 

Tax Considerations:

 

• At Exercise: ISOs, when exercised, do not create a taxable event at the federal level, although the bargain element may be subject to Alternative Minimum Tax (AMT).  We recommend consulting with a tax advisor to properly evaluate the potential AMT tax liability.

• At Sale: The sale of stock acquired through ISOs can result in a capital gain or loss.  The tax treatment is favorable if the stock is sold at least two years after the grant date and one year after the exercise date, qualifying for long-term capital gains.  Otherwise, the sale may be considered a disqualifying disposition, potentially subject to ordinary income tax rates.

 

Financial Planning Considerations:

 

• Valuation & Diversification: ISOs should be valued as a component of compensation and factored into overall portfolio diversification from an investment perspective.  Holding a significant portion of wealth in a single stock carries risk.

• Tax Planning: A strategic plan for the timing of exercise and sale is critical to minimizing tax consequences.  Consult with a tax advisor, particularly concerning AMT implications.

• Cash Flow Planning: Exercising ISOs requires a cash outlay to pay the strike price. Employees need to plan accordingly, especially if they intend to hold the stock for the course of the long-term capital gains qualifying period.

• Employment Changes: Leaving the company can affect ISOs. Typically, the ISO plan stipulates a limited time to exercise vested options after employment termination.

• Market Conditions & Company Performance: Stay informed about market conditions and the overall economic environment.  Understand the competitive landscape and industry trends that could impact your company’s stock price and the value of ISOs.

 

Potential Early Exercise:

 

Early exercise refers to the act of exercising stock options before they have vested.  Check the terms of your ISO plan to determine if this option is available to you.  In the context of ISOs, early exercise may have certain tax advantages by allowing the employee to start the clock on the holding period for long-term capital gains tax treatment prior to vesting.  Early exercise can also help minimize the amount subject to Alternative Minimum Tax (AMT) by locking in a lower bargain element if the stock price is expected to appreciate.  However, If the stock’s value decreases after early exercise, the employee might incur a loss.  Also, if an employee leaves the company before the shares are fully vested, the unvested shares may be forfeited, depending on the company’s policy.

 

In conjunction with early exercise, employees may opt for an 83(b) election with the IRS, allowing them to pay taxes on the bargain element at the time of the early exercise, which can be beneficial if the stock is expected to appreciate significantly by the time it vests.  To make an 83(b) election, the employee must file with the IRS within 30 days of the purchase of the unvested stock, pay tax on the bargain element, and send a copy to their employer.  However, the risk is that if the shares decrease in value or if the employee leaves the company before the shares vest, the upfront tax paid cannot be recovered.

 

Conclusion

 

Incentive Stock Options are a valuable form of equity compensation that allow employees to participate in the financial benefits of company building.  However, ISOs require careful financial planning and consideration of tax implications, market conditions, and individual financial circumstances.  We recommend consulting financial and tax advisors with expertise in equity compensation planning.  If you need help finding one, do not hesitate to reach out.  We are here to help you find a trusted financial advisor that is right for you.