In this post, we are going to look at another popular form of equity compensation—the stock option plan.
The Ins and Outs of Incentive Stock Options (ISO) | Cordant Wealth Partners
Specifically, Incentive stock options or ISOs. ESPP: Buying the stock at a discount e. ISOs give employees the option to buy shares in their company at a later date for a set price today. However, with an option, you get to defer the decision to exercise until a future date, allowing you to see where the share price is at the time.
RSUs, on the other hand, always have value except in the case of a company bankruptcy. There are three key dates you must know when it comes to ISOs. These are:.
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Of the key dates listed above, the expiration date is the most critical. In this scenario, all or enough shares are sold to cover the strike price. The value of your ISOs is either taxed at ordinary income tax rates or if certain criteria are met, more favorable long-term capital gains tax rates. It may be awarded as a hiring bonus or to make up for compensation and benefits, including in-the-money options and nonqualified retirement benefits, forfeited by leaving a prior employer. Of course, the very essence of restricted stock is that you must remain employed until the shares vest to receive its value.
While you may have between 30 and 90 days to exercise stock options after voluntary termination, unvested grants of restricted stock are often forfeited immediately. Fewer Decisions. Unlike a stock option, which requires you to decide when to exercise and what exercise method to use, restricted stock involves fewer decisions. When you receive the shares at vesting—which can be based simply on the passage of time or the achievement of performance goals—you may have a choice of tax-withholding methods e.
Restricted stock is considered "supplemental" wages, following the same tax rules and W-2 reporting that apply to grants of nonqualified stock options. Tax Decisions. The most meaningful decision with restricted stock grants is whether to make a Section 83 b election to be taxed on the value of the shares at grant instead of at vesting. Whether to make this election, named after the section of the Internal Revenue Code that authorizes it, is up to you.
If a valid 83 b election is made within 30 days from the date of grant, you will recognize as of that date ordinary income based on the value of the stock at grant instead of recognizing income at vesting. As a result, any appreciation in the stock price above the grant date value is taxed at capital gains rates when you sell the stock after vesting. While this can appear to provide an advantage, you face significant disadvantages should the stock never vest and you forfeit it because of job loss or other reasons.
You cannot recover the taxes you paid on the forfeited stock. For this reason, and the earlier payment date of required taxes on the grant date value, you usually do better by not making the election. However, this election does provide one of the few opportunities for compensation to be taxed at capital gains rates. In addition, if you work for a startup pre-IPO company, it can be very attractive for stock received as compensation when the stock has a very small current value and is subject to a substantial risk of forfeiture.
Here, the downside risk is relatively small. Unlike stock options, which rarely carry dividend equivalent rights, restricted stock typically entitles you to receive dividends when they are paid to shareholders. However, unlike actual dividends, the dividends on restricted stock are reported on your W-2 as wages unless you made a Section 83 b election at grant and are not eligible for the lower tax rate on qualified dividends until after vesting.
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Disclosure: The information listed above is for educational purposes only. For tax advice, please consult your accountant. I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future. For business owners, selling the business is often the single most important financial transaction in their lifetime. Since this is such an important event, we created a video series that will guide business owners through the.
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ISOs may be issued both by public companies and private companies, with ISOs being common as a form of executive compensation for public companies, and common as a form of equity compensation in private start-up companies.
Incentive Stock Options Checklist
Rather, if the shares are held for 1 year from the date of exercise and 2 years from the date of grant a "qualifying disposition" , then the profit made above the strike price is taxed entirely as a long-term capital gain, at a maximum rate of Tax treatment for the incentive stock option was created by the Revenue Act of The introduction of restricted shares and performance shares in the s and s diminished its popularity, but stock options continued to dominate through the s, s, and s.
In October , section a of the tax code was added by the American Jobs Creation Act of , which set rules requiring the strike price of the option grant to be at least the fair market value, giving rise to the term a valuation. In , law professor Erik Lie published a report into the options backdating involving changing the strike price and date of an option after issue, which led to over SEC and DOJ investigations, resulting in 12 criminal sentences.
As of , stock options including ISOs are no longer the most common form of long-term equity incentive rewards for executives, with about half given as performance shares, a quarter as RSUs , and a quarter as stock options. If the shares are sold before this required holding period a "disqualifying disposition" in the same tax year, then the difference between the price at the time of exercise minus the strike price is taxed as ordinary income, and any additional gain on top of the exercise price is taxed as a short-term capital gain.
Short-term capital gains are subject to the same tax brackets as ordinary income but are also subject to the 3. If the incentive stock option is sold above the strike price but below the exercise price in the same tax year, the income is recognized solely as ordinary income. If sold before the required 1-year holding period in a different tax year. Even if a disqualifying disposition is made, if the shares exercised are not sold in the same tax year, the holder must calculate to see if any alternative minimum tax is owed. Although ISOs have more favorable tax treatment than NSOs non-qualified stock options or nonstatutory stock options , they require the holder to take on more risk by holding the stock for a longer period of time if the holder is to receive optimal tax treatment.
However, even if the holder disposes of the stock within a year, it is possible that there will still be marginal tax deferral value as compared to NQOs if the holding period, though less than a year, straddles the ending of the taxpayer's taxable reporting period.
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Ordinary income from incentive stock options, unlike wage income or income from NSOs, is also not subject to payroll taxes such as FICA.