ISOs (Incentive Stock Options): Your Guide to Tax Optimization and Maximizing Profits

By: AJ Ayers, CFP®

In the tech industry, equity compensation is often a key part of the package to attract top talent. 

Stock options comprise a significant portion of the average startup employee's net worth. 

However, not all stock options are created equal. ISOs come with unique tax benefits that can make them particularly attractive.

Consider this: according to Secfi's State of Stock Options Report, stock options make up 86% of the total net worth of the average startup employee. 

Additionally, the same report reveals that 24% of startups reduced their fair market valuations in 2022, which can significantly impact the value of your ISOs. This underscores the importance of understanding what you're getting into.

What Are Incentive Stock Options?

Incentive Stock Options (ISOs) are stock options that enable employees to receive a portion of their compensation in the form of an option to purchase company shares at a specific price. ISOs are an appealing option for employers, as it can help align the interests of employees with the long-term success of the company. It's worth noting that there is a distinction between ISOs and other types of stock options, such as non-qualified stock options (NSOs);

ISOs have certain tax advantages. For example, when an employee exercises their ISO, any income from the spread between the strike price and the fair market value on the day of exercise is excluded from ordinary income. That’s what differentiates ISOs from NQOs. With NQOs, that spread is taxed as ordinary income. With ISOs, that spread may be subject to Alternative Minimum tax, but often the amount of tax is lower than ordinary income tax and can be recouped in future years. Gains from the sale of ISOs held for at least one year from exercise are treated at lower capital gains rates, sometimes resulting in outsized profits for employees who were able to exercise their ISOs while the strike price and fair market value were still low. 

There are, however, specific requirements and limitations that come with the use of ISOs. For instance, they're only granted to employees of the company, not contractors or consultants. 

Additionally, the total fair market value of ISO shares exercisable annually by employees is limited to 100,000 USD. Lastly, ISOs are typically subject to a vesting schedule, meaning employees must work for the company for a certain period before the options are exercisable.

Who Can Receive ISO Stock Options?

ISOs aim to reward and retain key employees in the company. While the decision to grant ISOs is at the discretion of the company's board of directors, recipients are generally those who contribute significantly to the company's success. These can include top-level executives, middle management, and dedicated individual contributors who bring exceptional value to the organization.

It is important to note that not all employees can receive ISOs. In most cases, companies have certain eligibility criteria that must be met by potential recipients. These criteria can vary from company to company and may include factors such as length of employment, job performance, or position within the organization.

One essential aspect to remember is that ISOs are exclusively available to employees, meaning non-employees, such as independent contractors or consultants, do not qualify for incentive stock options.

How Are ISO Stock Options Different from NSOs?

\When you exercise an ISO, there is no immediate income tax obligation. Instead, the difference between the exercise price and the fair market value of the stock is subject to long-term capital gains tax, provided you meet the appropriate holding period requirements. On the other hand, when you exercise a non-qualified stock option, the difference between the exercise price and the fair market value is considered ordinary income and is subject to income tax.

Another notable difference between the two types of stock options is the eligibility criteria. ISOs are reserved for employees only, while NSOs can be granted to employees, directors, and even non-employee consultants. This gives companies greater flexibility when using stock options as compensation.

Both ISOs and NSOs can have similar terms and conditions regarding vesting schedules and expiration dates. However, ISOs typically have shorter exercise windows upon termination of employment compared to NSOs, which allows for a longer period to exercise the options after an employee leaves the company.

The tax treatment of ISOs can be more complex than NSOs, especially regarding the Alternative Minimum Tax (AMT). Exercising ISOs can potentially trigger the AMT, which might offset the tax benefit gained from holding the stock options.

What Are the Tax Benefits of ISO Stock Options?

One of the key tax benefits of ISOs is their treatment under the federal income tax code. When an employee exercises an ISO, there's no immediate income tax liability on the difference between the option price and the market value of the stock. Intriguingly, this allows employees to defer their tax liability until they decide to sell the shares obtained through ISOs. However, employees should be aware of Alternative Minimum Tax when exercising ISOs. 

Furthermore, if an employee meets specific holding requirements, the eventual sale of the ISO-acquired stock could qualify for long-term capital gains tax treatment, with rates typically lower than ordinary income tax rates. To achieve this favorable treatment, the employee must hold the shares for at least one year after the exercise date and two years after the grant date. This strategy can significantly reduce the overall tax burden on the proceeds from ISOs.

Another tax advantage specific to ISOs is their exemption from payroll taxes like Social Security and Medicare. Unlike nonqualified stock options, which may incur payroll tax obligations, ISOs can save employees and employers on these costs.

The tax benefits of ISOs can also extend to the employer. When an employee exercises an ISO and meets the holding requirements, the company cannot take a tax deduction for the compensation expense. While this might seem negative, it can be a tax-efficient way to reward employees without directly impacting the employer's tax liability.

When Can ISO Stock Options Be Exercised?

Timing is critical in exercising ISOs, especially regarding potential tax implications. If you've been granted ISOs, one strategy can be to exercise as soon as you’re able (upon vesting). This strategy often applies to early employees who may be granted ISOs with a very low price. That way, the holding period begins and the potential to qualify for long term capital gains is greater. 

Another possible strategy is to wait until the share value has greatly appreciated. In that case, a complex calculation of how much to exercise without triggering Alternative Minimum Tax can help you potentially lock in a long term capital gain, if you’re willing to hold the shares for a while year after exercise. 

It’s important to note that the holding period requirements for ISOs must be met to receive preferential tax treatment. If you exercise your options and then sell the stock after meeting these holding period requirements, long-term capital gains treatment will generally apply.

To ensure the tax benefits of ISOs, you must hold the shares purchased by exercising the option for at least one year and not sell the stock until at least two years after the options were granted. This waiting period helps maximize the potential capital gains and ensures that the sale adheres to the required holding period. 

Furthermore, when you exercise the option, it's crucial to consider the current stock price and your overall financial situation. Regularly reviewing your stock options and their potential value can help make an informed decision about when to act. Remember that the stock price is subject to fluctuations, influencing your gains or losses.

Market conditions and the company's financial performance can also influence the optimal timing for exercising ISOs. Therefore, staying informed about the relevant factors and maintaining open communication with your financial advisor can ensure you make well-considered decisions about your ISOs.  

What Happens to ISO Stock Options if an Employee Leaves the Company?

If an employee leaves the company, the unvested ISOs typically are forfeited. When this happens, the employee loses the chance to exercise these options. Remember that ISOs come with a vesting schedule - a predetermined timeline set forth by the employer. Employees must understand the potential consequences of leaving the company before their options have fully vested.

Another aspect for employees to contemplate is the actual exercise window after departure. Depending on the company's specific stock option plan, an employee might have a limited time - usually 90 days - to exercise any vested ISOs after leaving their job. If the employee doesn't exercise these options within the specified time frame, they will forfeit the options altogether.

What Are Some Pros and Cons of ISO Stock Options?

One of the primary advantages of ISOs is their potential for favourable tax treatment. When held for the required holding period, ISOs can qualify for long-term capital gains treatment, leading to lower tax rates. This tax benefit is especially appealing to employees in higher tax brackets. 

However, this advantage doesn't come without its own set of complexities. The dreaded Alternative Minimum Tax (AMT) can come into play when exercising ISOs, potentially creating an additional tax liability. Navigating the AMT can be difficult, so it's vital to be well-informed about the potential AMT liability when exercising ISOs.

That said, ISOs have potential for significant financial gains. Employees granted ISOs participate in the growth of their company's stock price. If the company performs well, the stock price increases, and the employee can realize substantial gains from exercising their options. Of course, this comes with the inherent risk in holding company stock. Employees need to consider the possibility that their company's stock may underperform or decline in value over time, reducing the value of their ISOs.

In terms of stock option design, careful consideration should be given to strike a balance among strategic, stakeholder, and motivational factors when granting ISOs. This includes vesting schedules and how options align with the company's overall compensation strategy. While stock options can provide powerful incentives for employees, they need to well designed to balance the employee's motivation with the impact on shareholder value.

Frequently Asked Questions

How do ISOs differ from RSUs?

ISOs provide the right to buy company shares at a predetermined price, called the strike price, after a vesting period. This vesting period usually lasts several years and motivates employees to stay with the company. In contrast, RSUs are grants of company shares subject to a vesting period, but employees receive the shares without paying a strike price. While ISOs offer potential tax advantages, RSUs are considered less risky as they don't require an upfront investment from the employee.

Can ISO Stock Options Be Transferred?

Typically, ISOs are not transferable to other individuals. They are usually only exercisable by the person who initially received the options. This feature provides incentives for employees to commit to the company long-term. Exceptions may exist in specific circumstances such as estate planning or inheritance, but generally, ISOs are non-transferable.

How Are ISO Stock Options Priced?

The company's board of directors determines value of ISO stock options at the time of granting. The board usually hires an independent expert to conduct a valuation of the company's shares based on various factors, such as financial performance, industry outlook, and overall market conditions. The price they set, also known as the strike price, becomes the fixed price at which the employee can purchase the company's shares once the options reach their vesting period. The Black-Scholes formula is sometimes used to help measure the company's cost of options.