Equity compensation in the form of restricted stock units (RSUs), restricted stock awards (RSAs), incentive stock options (ISOs), and nonstatutory stock options (NSOs) often account for a significant portion of a tech or startup employee’s compensation package. ISOs offer unique tax benefits, providing the potential for significant financial gains. However, dealing with their complexities requires careful planning to minimize their tax impact and overall financial risks. Today, we will break down what ISOs are, how they are taxed, the role of the alternative minimum tax (AMT), and considerations for managing your ISOs effectively. 

What Are Incentive Stock Options?

ISOs, like all employee stock options, are a type of equity compensation typically granted to executives and employees of early-to-mid-stage startups, giving them the right to purchase company stock at a predetermined price (the exercise/strike price) within a specified time frame. Unlike NSOs, ISOs offer significant tax advantages when managed correctly. If held for the required period, the shares have the potential to receive preferential long-term capital gains tax treatment on the difference between the strike price and the fair market value (FMV) of the option on the date of exercise. This difference is known as the bargain element. In contrast, the bargain element on your NSOs gets taxed as ordinary income when you exercise shares, resulting in higher tax burdens. To learn more about the differences between ISOs and NSOs, check out our article How Employee Stock Options Work and How to Manage Them. 

To qualify for ISO status: 

• The exercise/strike price must be at least the FMV of the stock on the grant date. For startups, this is typically based on your company’s latest 409A valuation. 

• The options must be exercised within 10 years of the grant date. 

• ISOs cannot be transferred (except in certain cases like death). 

• Only $100,000 of ISOs can become exercisable for the first time in any calendar year. 

How Are ISOs Taxed?

The taxation of ISOs depends on when you exercise and sell the shares. There are two key scenarios:

1. Qualifying Disposition

If you hold the shares for at least two years from the grant date and one year from the exercise date, the sale qualifies for favorable long-term capital gains tax treatment. With a qualifying disposition, the bargain element gets taxed at long-term capital gains rates.  

2. Disqualifying Disposition

If you sell the shares before meeting the holding period requirements, the bargain element is taxed as ordinary income, and any additional gain is taxed as capital gains. 

What Is the Alternative Minimum Tax? 

The AMT is a parallel tax system that ensures taxpayers pay a minimum amount of tax, even if they have significant deductions or credits under the regular tax system. You are required to calculate both your regular tax and AMT burdens each year and pay the greater of the two. Few taxpayers have seen their AMT burden exceed their regular tax burden since the passage of the Tax Cuts and Jobs Act in 2017. This is due, in large part, to an increased AMT exemption amount and a $10,000 cap on the amount of state and local taxes (SALT) that you can deduct against your regular tax burden. However, those who exercise a significant amount of ISOs in a given year can be subject to AMT. 

How Are ISOs Impacted by AMT?

When you exercise ISOs, the bargain element (again, this is the FMV of the shares on the exercise date minus the options exercise/strike price) is considered income for AMT purposes but is NOT considered income for regular tax purposes. This can cause your AMT tax burden to exceed your regular tax burden. AMT can significantly reduce the tax benefits associated with ISOs since it increases the amount of tax you need to pay the year you exercise your options. The effects of AMT are compounded by the fact that you pay additional taxes without receiving the proceeds from your company stock (since AMT is due when exercised even if you haven’t sold shares of the stock).  

We expect a significant tax bill from Congress over the next two years. We will watch this carefully to see if AMT is affected. 

Strategies to Minimize AMT Impact

1. Exercise up to the AMT Crossover Point

The AMT crossover point is where the additional income from exercising ISOs triggers AMT liability. By carefully tracking your income and deductions, it is possible to exercise just enough ISOs to avoid crossing into AMT territory. This strategy allows you to maximize the tax benefits of ISOs while minimizing the impact of AMT. However, those who receive significant ISO awards each year may not be able to exercise all their options while staying below the crossover point. This can cause you to accumulate a considerable amount of unexercised ISOs, increasing your concentration risk and potentially causing a larger AMT burden down the road.  

2. Exercise Early in the Year and Sell 1+ Year Later

Another way to mitigate the impact of AMT is by exercising ISOs early in the year. By exercising your options early in the year (typically in January or February) and selling them more than a year later, you can achieve a qualifying disposition and benefit from long-term capital gains tax treatment. Additionally, this allows you to sell the shares before the AMT tax bill is due (typically on April 15 of the following year), increasing the chances that you have cash on hand to cover any AMT liability. It’s worth noting that this strategy typically only works when the stock is publicly traded or if there is a way to sell the shares to a third party. 

3. Recoup AMT Payments with an AMT Credit

If you end up paying AMT because of ISOs, you may be able to recover some or all of that payment in future years as an AMT credit. This credit applies when your regular tax exceeds your AMT in subsequent years, effectively reducing your future tax liability. This typically occurs in the year you sell your company shares. This is due to the stock’s AMT basis usually being higher than its regular tax basis, causing your AMT burden to be less than your regular tax burden.  

Now that we have a solid understanding of what ISOs are, how they are taxed, and how to mitigate the impact of AMT, let’s look at the main considerations when developing a plan for your ISOs. 

Key Considerations for Managing ISOs

1. Optimizing ISO Taxation

As we’ve discussed, many of the benefits associated with ISOs deal with how they’re taxed. Minimizing the taxes on your ISOs by pursuing a qualified disposition is an important consideration. However, there are other elements that can wipe out this benefit that must be accounted for. 

2. Managing Cash Flow Impact

It is important to address the impact of exercising your ISOs on your cash flow. Exercising ISOs requires you to actually purchase the underlying shares of company stock at the options exercise/strike price. Additionally, you may have to come up with additional funds to pay the AMT liability caused by the bargain element. If you do not have the excess cash flow to cover these items, then you likely will not want to pursue a qualified disposition and may be better off exercising and selling the shares instead. Planning ahead is crucial to ensure you have the liquidity to cover these costs without jeopardizing your financial stability. 

3. Mitigating Concentration Risk

Holding too much of your wealth in a single company’s stock increases your financial risk. This is why diversification is so important. There are countless stories of employees investing significant amounts of their net worth in their employer’s stock. This can seem great when the company’s doing well. However, things can come crashing down fast, causing you to lose everything. (Anyone remember Enron?) By holding your ISOs in pursuit of a qualified disposition, you are inherently holding company stock for an extended period of time. You can mitigate your concentration risk by exercising and selling ISOs gradually. Doing so can reduce that risk while spreading out the tax impact. This is a great strategy if the stock is publicly traded or traded on a secondary market. It does not work so well for pre-IPO companies since there typically isn’t a way to sell your exercised shares. For these employees, it usually makes sense to simply hold your options until a liquidity event occurs. 

4. Monitoring Market Risk

Arguably one of the biggest considerations regarding any form of equity compensation is market risk. This is the risk that the stock goes down (or up) in value. Market volatility poses a unique challenge for ISO holders. A significant drop in stock price (e.g., 15% or more) after exercising can often wipe out the anticipated tax benefits of a qualified disposition (since the difference between ordinary income tax rates and long-term gain tax rates is typically around 15%). Additionally, if the price falls far enough, you may not be able to sell your shares to cover your AMT burden. You can mitigate this by selling your shares immediately after exercise. You could also pursue a combination of qualified and disqualified dispositions. Ultimately, this decision can hinge on how much market risk you are willing to take, how much tax risk you are willing to take, and how reliant you are on the proceeds from your ISOs to achieve your financial goals.  

Conclusion

Managing ISOs effectively requires a deep understanding of their tax implications, the impact of AMT, and the financial risks involved. By employing strategies like exercising up to the AMT crossover point, timing exercises early in the year, and leveraging AMT credits, you can minimize your tax burden and maximize your financial gain. Additionally, addressing considerations like cash flow management, concentration risk, and market volatility ensures a comprehensive approach to your equity compensation. 

If you have any questions or concerns regarding ISOs or your financial situation in general, please reach out to our team. A financial advisor experienced in equity compensation can help you navigate these difficult topics and develop a tailored strategy aligned with your unique situation and goals.