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Incentive Stock Options: What You Need to Know

What Are Incentive Stock Options?

Stock options are one of the most popular forms of equity compensation, but they’re also largely misunderstood. There are two types of stock options, Incentive Stock Options (ISOs) and Nonstatutory Stock Options (NSOs). Which type you hold will largely dictate your strategy around holding, exercising, and selling your stock. In this article, we’ll focus on Incentive Stock Options, which is the type of stock you would likely be granted as an employee of a company.

Incentive stock options (ISOs) – also referred to as Qualified Stock Options – can be granted only to employees of a company (independent contractors are not permitted).

While many people get excited about options and what their value might mean for their financial futures, it’s good to remember there are certain strategies you can either implement or avoid to ensure you are getting the outcome you want.

Tax Treatment of Incentive Stock Options

ISOs potentially have more favorable tax treatment than many other types of employee equity compensation.

This is because they are not taxed for regular tax purposes until they are sold. However, to qualify for the treatment as capital gains tax on a standard tax return, you must hold the shares two years from grant and one year from exercise (if you don’t meet this requirement, then the sale will be treated as a disqualifying disposition). If these dates are met and the value of the stock increases, you’ll only owe long-term capital gains tax when you sell.

While ISOs are not taxed for regular tax purposes until they are sold (if you meet the holding requirements), the alternative minimum tax (AMT) may be applicable at time of exercise. If you pay AMT upon exercise of the options, you may be entitled to an AMT tax credit that can be used to lower your income tax bill in subsequent tax years when the amount you owe is more than it would have been under the AMT.

Note that the bargain element (again, the difference between the grant price and the exercise price) is considered an AMT preference in the year that you exercise your ISOs. In order to determine if you are subject to AMT, you have to complete your regular IRS Form 1040 and Form 6251 to determine if you are subject to AMT. You’ll owe taxes on the greater of your regular tax or the tax determined under the AMT calculations.

Read More: Tax Planning

How to Exercise Incentive Stock Options

ISOs can be a bit trickier to exercise than NSOs because tax consequences depend on how long you hold the shares.

If you hold on to your shares for the qualification period (two years after grant, one year after exercise) and things go well, then the stock will go up in value, and as mentioned before, you will likely only owe long-term capital gains rates when you sell. You may, however, still need to put up a sizable amount of cash upon exercise (depending on the strike price). And it’s possible your stock’s value could just as easily go the other way, which means you would erase any potential gains – and in some cases, may have to pay out of pocket to cover taxes.

Talk to your financial advisor or tax expert to learn more.

Read More About Equity Compensation:

Disclaimer: The information and content provided herein is general in nature and is for informational purposes only. It is not intended and should not be construed as a specific recommendation, or legal, tax or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professional to help answer questions about specific situations or needs prior to taking action based on this information. Tax laws and authorities are subject to change, either prospectively or retroactively, and any subsequent change could have a material impact on your situation.

The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.

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