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Tax Obligations for Incentive Stock Option Exercises

Posted by Ryan M. Newburn | Jun 21, 2021 | 0 Comments

What are incentive stock options (ISOs)?

Incentive stock options (“ISO”) are corporate benefits that are part of an employee's contractual benefits package. These benefits allow the employee to buy shares of the company's stock at a discounted price with the extra benefit of possible tax breaks on the profit earned on the stock. Generally, companies typically give ISOs to top-level management, like CEOs or CFOs, or highly valued employees as a type of passive income instead of a higher salary. They are a heavily negotiated term in the employee contracts and are used to persuade sought-after talent to join corporations due to the hefty profits they can yield. The hefty profits stem from the fact that profits made from qualified ISOs are taxed at the lower capital gains rate as opposed to the higher rate for ordinary income.

When do companies issue ISOs?

For the most part, publicly traded companies issue ISOs, or sometimes private companies that plan to go public in the future. When a company is publicly traded on a stock exchange, it allows the general population to purchase shares of the company, "stocks," at the company's listed stock price at a given time. Then, the stockholder can hold the stock for a period of time in hopes that the stock price rises and that they can sell the stock for a profit.

For example, Tesla stock ("TSLA") was valued at roughly $200 one year ago. Now, only one year later, TSLA has a stock price of $615, so if a person bought TSLA stock at $200 one year ago, they would make a profit of $400 for each share they sold if they sold the stock today. The profit made for a stockholder who owned multiple shares would be astronomical: a person who owned 100 shares of TSLA a year ago would make a profit of $40,000 if they sold the stock today. This example shows how offering a lucrative stock option package in an employment contract can be used as a persuasive bargaining chip to lure valued talent to companies and how these employees can reap great benefits when they do receive ISOs.

What is a “strike price”?

ISOs are issued, or “granted,” at the price the employer sets called the “strike price." Traditionally, this is the price that the company's shares are valued at when the employee signs their employment contract, and the date the ISOs are issued is called the "grant date." ISOs typically require a period of time to "vest" before the employee can exercise the option. Employers usually use either a standard vesting schedule, which is a one to three-year cliff schedule, or a graded vesting schedule. When using a cliff schedule, all of the ISOs vest after one to three years have passed.

Conversely, a graded vesting schedule is when an employee's stocks are invested in increments - such as on-fifth a year, ultimately becoming fully vested in the ISOs in five years. Once the vesting period expires, the employee can buy the shares at the strike price or "exercise the option." Here, the employee assumes the role of a regular market price buyer, except they have the "option" to buy the stock at the lower predetermined strike price. The employee can sell the stock for its current value after buying the shares and make a substantial profit on the difference between the strike price and the stock's current market price. However, if the stock price is not higher than the strike price when the options vest, the employee can simply hold onto the options until the expiration date in hopes the stock price will rise. ISOs usually expire after ten years.

What is the difference between ISOs and NSOs?

There are several differences between ISOs and non-qualified stock options ("NSOs"). Which one you should offer, or which one you can even offer, will depend on a variety of things:

  • Granting Entity: Only a corporation can grant ISOs. LLCs and Partnerships can offer NSOs.
  • Eligible Recipients: Only employees can receive ISOs, but NSOs can be granted to a broader class of service providers like advisors and consultants.
  • Holding Requirement: ISOs must be held for two years after the grant, and the shares obtained upon exercise must be held for one year after exercise to qualify for long-term capital gains tax. NSOs only have to be held for one year after the date of exercise.
  • Tax at Exercise: An employee will most likely not pay taxes on an ISO when exercised. Conversely, when an NSO is exercised, the employee must pay ordinary tax on the difference between the market price of the share at exercise and the original granted price, the "spread."
  • Expiration: ISOs cannot be open for longer than ten years, whereas NSOs don't have any expiration restrictions.
  • Exercise Following Termination: An ISO must be exercised within three months of termination. An NSO does not have a similar restriction.

For employers, NSOs is the most advantageous because it can elect tax deductions when the service provider exercises the option. After all, the NSO stock option is treated as ordinary income in relation to the service provider. A company using an ISO gets no tax reduction. One benefit that ISOs offer to companies is that they do not require the expensive and cumbersome 409A valuation process that offering NSOs requires.

Why are ISOs more favorable when it comes to taxes?

ISOs are favored due to their beneficial tax treatment of employee's profits made on the sale price of the stock offered under the option. Suppose the employee meets the applicable holding period of two years after the grant and one year after exercise. In that case, the profit will be taxed under the long-term capital gains rate, which is either 0%, 15%, or 20%, depending on the employee's income. Therefore, the tax will be the sale price minus the exercise price at the applicable long-term capital gains rate.

Conversely, NSOs will not offer the employee the same desirable tax treatment. When an NSO is exercised, the employee must pay ordinary income tax on the exercise price minus the original grant price plus capital gains taxes on the ultimate sale price minus the exercise price. This ordinary income tax treatment results in a substantially higher tax burden because the marginal income tax rate for individual fillers can range between 10% to 37%, depending on income.

This example will illustrate how significant this difference can be:

Tesla offers you an option to buy 100 shares of stock at $200 as an NSO with a vesting date of two years. Two years later, you exercise the option when the stock price is valued at $600. Then you sell the stock price one year later when it is valued at $700. You are filing as an individual with $250,000 taxable income.

Here, you would pay to ordinary income tax at 35%, based on your marginal income tax bracket, on the $40,000 spread ($600 x 100) – ($200 X 100) between the exercise price and the grant price.

Then, you would have to pay a 15% long-term capital gains tax on the $10,000 ($700 x 100) – ($600 x 100) profit you made on the sale price and exercise price. However, if we use the same facts except now an ISO was offered, you would only have to pay a 15% long-term capital gains tax on $50,000 ($700 x 100) – ($200 x 100), representing the difference between the sales price and the exercise price.

What can you do with ISOs that might affect your taxes?

When you exercise your option to purchase your shares and hold them, you still must report this on your tax returns. Using the Tesla example above, when you exercise your option to buy 100 shares at $200, you must report your "bargain element." This is the current market price of the stock ($600) minus the exercise price ($200) multiplied by the number of shares bought (100). Here, you would have to report $40,000 as an adjustment for the Alternative Minimum Tax ("AMT") on your Form 6251. If you sell these shares within a year after exercise, you must report the sale on your 2020 Schedule D, Part I as a short-term sale where the profit would be taxed at an ordinary tax rate. This an example of a disqualifying sale that prevents you from benefiting from the favorable capital-gains tax rate, and thus, the options lose their ISO status. Any sale before two years after the grant date or one year after the date of exercise will be a disqualifying sale.

On the other hand, a qualifying sale is when two years passed between the grant and sale dates, and one year has passed between the exercise date and sales date. For example, Tesla grants you an option to purchase 100 stocks at $200 on January 1, 2018. Those shares vest on January 1, 2020, when the stock is valued at $500, and you sell your shares on February 1, 2021, when the stock is valued at $600. You must report the sale and the profit made ($40,000) on your 2020 Schedule D, Part II as a long-term sale. Also, you must report the bargain element when exercising the option on Form 6251 for alternative tax minimum (“AMT”) tax and make an adjustment on the same form to the AMT for the year that you sold the stocks.

When do I have to report an ISO adjustment for the Alternative Tax Minimum?

The AMT operates an alternative minimum tax floor to ensure that high-income taxpayers pay at least a certain amount in taxes. The ATM only applies to single filers who make more than $72,900. Simply put, the AMT will not apply when you exercise an ISO and sell it within the same calendar year, but it will apply in all other circumstances. If you don't sell the ISO in the same calendar year, you must report the bargain element as a preference item on Form 6251 for AMT. If you want to avoid the AMT, you can sell the stocks in the same year you exercise your option, and the ISO will be taxed as ordinary income as a short-term sale.

Another difference to be mindful of is statutory options and nonstatutory options. Statutory stock options are options granted under an employee stock purchase program or ISO. If an employer grants you a statutory stock option, you usually don't have to include any amount in your gross income when you exercise the option so long as you meet the special holding requirement periods. However, you may be subject to the ATM depending on whether you sell the stock in the same year the option was exercised. If an employer grants you a nonstatutory stock option, the income you will report will depend on whether one can readily determine the fair market value of the option. An option's value can be readily determined when it is actively traded on an established market, like the New York Stock Exchange. When the value is not readily determinable, you must include in your income the difference between the amount paid when you exercise the option and the fair market value of the stock received. A taxable event occurs later when you sell the stock received when you exercised the option.

Is my employer required to withhold income tax when I exercise my ISO?

Your employer is not required to withhold income taxes when you exercise your ISO because it is presumed it will not be treated as ordinary income. However, if you do not meet the holding requirements and your sale is deemed a disqualifying sale, you will have to pay ordinary income taxes on the transaction. Likely, you could potentially be liable for the ATM, depending on the circumstances.

What are a company's tax reporting obligations for ISO exercises?

A company must give an employee who exercises an ISO and the IRS a copy of Form 3921 within a month of the following calendar year that the option was exercised. This Form includes the date the option was granted and exercised, the exercise per share, the fair market value per share on the exercise date, and the number of shares transferred. This reporting requirement only applies to the exercise of ISOs, not the exercise of NSOs. A company also doesn't have to provide the From 3921 to a nonresident alien and someone for whom the company is not required to provide a Form W-2.

How does an employee stock purchase plan (ESPP) affect my taxes?

ESPPs are very similar to ISOs, granting employees options to purchase company stock at discounted prices. Usually, ESPPs do not levy any taxes when the option is exercised. A taxable event does not occur until the stock is sold. ESPPs, like ISOs, have certain holding requirements that must be met in order for the sale to be a qualifying sale and treat profits as capital gains. The major difference between ISOs and ESPPs is that ESPPs have nondiscrimination rules, are offered to a broader group of employees, and ESPPs may be tied in with an employer's payroll process. ISOs do not have discrimination rules and are generally only offered to executive-level employees.

What should I consider before exercising my ISO?

You should consider whether the risk of taking deferred income is worth it. Generally, your stock options will not vest for two years, and you will be required to hold the stock for an additional year if you want to maintain capital gains tax treatment. You should inquire into the company's financial viability to conclude if the company will be more valuable in the future because if it is not or folds, your option will be worthless. Also, you should calculate whether the ATM will apply to you when you ultimately sell your ISOs.

ISOs can be tremendously rewarding, but they can also be quite complex. You should contact an experienced attorney to help guide any decisions regarding ISOs or other employee benefits packages. Newburn Law has the vast business experience and expertise to help you craft the best strategy to handle all the complex problems that ISOs can bring. Contact us now to learn about how we can help you.

About the Author

Ryan M. Newburn

Ryan Newburn is a business and legal expert trusted by Executive Teams and Boards of Directors to apply sound business principals to solve legal and financial problems. Ryan's practice focuses on mergers and acquisitions, financings, corporate formations and corporate governance in a broad range of industries including energy, distribution services, healthcare, medical devices, and technology. Leveraging his formal business training and years of practical experience, including as an executive at public and private companies, Ryan has advised hundreds of companies in dozens of industries of unique legal and financial issues.

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