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Incentive Stock Options (ISO's)

Incentive stock options are typically the most tax favorable type of stock option, yet also the most complex. They are typically issued to early employees of private companies, but we have seen some issue very close to IPO dates.  ISO's give you the right to purchase company stock at a stated price (the strike price).  When exercising ISO's, you purchase the company stock at the strike price and could choose to either hold onto the shares or sell the stock.  If the company is pre-IPO (has not gone public yet), typically your only choice is to hold onto it.  If you sell the stock more than a year after you exercise the shares and more than two years after they were granted to you, you pay long-term capital gains taxes on the profits. 

Here's where the tax implications get tricky and its important to be working closely with a tax advisor when considering exercising ISO's.  The difference between the strike price and the fair market value (FMV) of the stock at the time of exercise is considered the bargain element.  If the bargain element is large, you could be subject to the Alternative Minimum Tax (AMT).  Even though you didn't sell any stock (you merely exercised your options and are now holding onto the actual shares of stock), you could still end up paying some AMT tax the following April when taxes are due.  If subject to AMT from exercising your ISO's, the tax you pay creates a credit that can potentially be used to offset future taxes in years where your standard tax calculation is greater than your AMT tax calculation.  

As stated, it can get tricky, so working with a financial advisor and tax professional who understand these implications is imperative. 

Generally, if you exercise your incentive stock options before your company goes public, unless you were granted a very large number of ISO's, the AMT implications are likely to be minimal.  After your company goes public, there is a greater likelihood that exercising ISO's will result in AMT tax implications. 

Every situation is unique, but generally speaking, it can be most tax efficient to exercise your ISO's before your company goes public and then sell them after the company is public and you have held the shares for over a year.  There is obviously the risks of the company not going public, or that the share price goes down in value, so it is important to think things through and have a plan ahead of time. 

Meet with one of our advisors today to discuss your stock options and develop a strategy for exercising and eventually selling them