What it means
A stock option gives the holder the right, but not the obligation, to buy shares at a set price called the exercise or strike price. If the market value of the shares later rises above that price, the holder can buy at the lower price and gain the difference.
ISOs are a version of this designed to be attractive to employees because of the way the tax law treats them. To qualify, the option must meet several rules.
It has to be granted under a written plan approved by shareholders, the exercise price must be at least the fair market value of the shares at the grant date, and the option must be exercised within a set number of years from the grant. There is also an annual limit on the value of ISOs that can first become exercisable by one person in any year.
The main tax benefit comes if the employee holds the shares long enough. Generally, the shares must be held for at least two years from the grant date and one year from the exercise date.
If both periods are met, the whole gain from the exercise price to the sale price is taxed as a long-term capital gain, and no ordinary income tax arises at exercise. There is a catch known as the alternative minimum tax.
The spread at exercise, which is the difference between the market value and the exercise price, is an adjustment item for that tax, so an employee can owe tax in the year of exercise on a gain they have not yet sold. For this reason, exercising a large number of ISOs without selling the shares can create a significant cash need.
If the holding periods are not met, the sale is a disqualifying disposition and part of the gain is taxed as ordinary income. Employers do not get a tax deduction for a qualifying ISO sale, while they can for a disqualifying one, and this affects how companies choose between ISOs and non-qualified options.
From a finance perspective, companies still record an expense for the option's fair value over the vesting period, whatever the tax treatment. Employees should take personal tax advice before exercising, as the interaction with the alternative minimum tax is complex.
In practice
Real-world examples
Example 1
A start-up engineer is granted 20,000 ISOs at $2 per share when the company is young. Five years later, after a successful sale of the company, she exercises and sells and, having met the holding periods, pays the capital gains rate on her gain.
Example 2
A finance director at a growing company decides to exercise ISOs but sells the shares within the same year because he needs cash. The sale is a disqualifying disposition, so part of his gain is taxed as ordinary income.
Example 3
An early employee exercises a large block of options in a year when the shares have risen sharply but cannot sell them because the company is private. He faces an alternative minimum tax bill of $40,000 in cash with no sale proceeds to pay it.
Think of it
Imagine buying a voucher today that lets you purchase a house for its current market price of GBP 200,000 in five years, no matter how much the neighbourhood improves. If the house is worth GBP 400,000 by then, you still buy it for GBP 200,000 and keep the difference.
Formula
Calculation
Spread at exercise = (market value per share - exercise price) x number of shares
Suppose an employee holds 10,000 ISOs with an exercise price of $5 per share, and the shares are worth $20 when she exercises. The spread is (20 - 5) x 10,000 = $150,000, which is an alternative minimum tax adjustment in the year of exercise. If she holds the shares for the required periods and sells at $30, her gain is (30 - 5) x 10,000 = $250,000, all taxed as a long-term capital gain.Case study
Seen in the real world
Kestrel Robotics is an illustrative, fictional private company that granted ISOs to its first twenty employees at an exercise price of $1.50. When a funding round valued the shares at $12, one engineer wished to exercise 30,000 options.
The spread was (12 - 1.50) x 30,000 = $315,000, and the exercise cost was 1.50 x 30,000 = $45,000. Because the shares were not tradable, she would have owed alternative minimum tax on the spread without any cash from a sale. The finance director arranged a tax briefing for all option holders and a plan to exercise in stages.
The illustrative lesson is that ISOs can be very valuable but they create cash and tax planning issues at exercise, and employers who explain the rules early help their staff avoid costly surprises.
Watch out
Common mistakes
- Exercising a large number of ISOs without checking the alternative minimum tax, which can create a tax bill with no cash from a sale.
- Selling shares too soon and turning a qualifying disposition into a disqualifying one, which removes the capital gains treatment on part of the gain.
- Assuming ISOs can be given to anyone, when they can only be granted to employees.
Questions
People also ask
What is the difference between ISOs and non-qualified stock options?
ISOs can get special tax treatment but have strict rules, while non-qualified options are more flexible and usually create ordinary income at exercise.
What are the holding periods for ISOs?
Generally the shares must be held at least two years from grant and at least one year from exercise to receive the favourable treatment.
Does the company get a tax deduction for ISOs?
Not for a qualifying sale, but it may get one if the employee makes a disqualifying disposition.