ISOs have become very common in tech companies and start-ups. ISO stands for incentive stock option, also referred to as statutory or qualified stock options. ISOs are a benefit that provides employees the right to buy shares of company stock at a discounted price with possible tax benefits on the profits. Continue reading for everything you need to know about incentive stock options.
What Are ISOs?
ISOs are a form of equity compensation granted to employees to allow them to purchase a set quality of company shares at a specific price with tax benefits. Normally ISOs are provided during the hiring process or as part of a promotion package. This form of equity compensation is used as deferred compensation to motivate and retain employees. Since ISOs need to be held for a specific period of time, the only way to take advantage of this benefit is by staying with the company for at least as long as it takes to utilize your ISOs. Additionally, the harder you work, the higher your company’s stock price will be, and the greater reward the employee will benefit from.
How Do ISOs Work?
The day the employee is granted ISOs is known as the grant date. After the grant date, your ISOs have a vesting schedule that shows the waiting period until the employee has ownership of the stock. Once your ISOs are vested, you have the ability to purchase a specific number of company shares and the strike price, which is listed in your ISO grant. You will be able to exercise your ISOs until the expiration date. Normally you have several years between vesting and expiration.
When it comes to vesting your ISOs, you need to be strategic. When your strike price is below the current market price of your company’s stock, this is a great time to exercise your options. In this situation, you can buy stock at the strike price and sell them back at the market price to earn a profit. If the strike price is above the market rate, avoid vesting your ISOs since it’s extremely unlikely to make a profit.
How Are ISOs Handled Tax-Wise?
The main advantage of ISOs is you do not have to report income when you receive a stock option grant or exercise your options. You only have to report the taxable income when you sell off your ISOs. Depending on how long you hold your ISOs between vesting and selling, your capital gains rate will vary.
However, you do have to report the bargain element, the difference between the grant price you paid and the fair market value on the day you exercise your options, as taxable compensation for the Alternative Minimum Tax in the year you exercise your ISOs unless you sell the stock the same year.
The Alternative Minimum Tax is a tax system that adds income that is tax-free to prevent different tax deductions for those who show a lower income amount under the regular tax system. To see if you owe any additional taxes under the Alternative Minimum Tax system, you must fill out Form 6251.
Getting Help With Your ISOs
The best way to use your incentive stock options to your advantage is by having a knowledgeable financial advisor on your side. Our advisors at Eagle Grove are experienced with equity compensation to help you take advantage of your ISOs to build your wealth. Schedule a consultation with us today to get started.