Understanding Taxes on Incentive Stock Options
Direct income is frequently the first consideration we have when a job offer presents itself. But there are other kinds of compensation that an employer can offer that also are valuable and could even cause less of a hit to your taxes each year. I’m talking about employee incentive stock options, or ISOs.
ISOs are a form of compensation that a company may offer as an incentive to motivate employees to contribute to a company’s well-being and reward them for its success. Not only can this help protect a company’s bottom line — particularly a small or up-and-coming business — but it can benefit employees’ bottom line as well. It motivates employees to work harder, aligning their goals with those of the employer, and if the stock grows, it can be financially rewarding.
And because of certain conditions under our tax law, ISOs also involve less of a tax burden on the employees who receive them. It may sound too good to be true — and sometimes it is. Here’s what you need to know.
The Basics of ISOs
The notion of tax benefits as they pertain to ISOs is highly complex, but in a nutshell, think of two compensation scenarios. In the first, you’re offered, for example, an annual salary of $200,000. In another, your offer is for $150,000 in income, and another $50,000 in ISOs.
In the first scenario, you’d be taxed at the $200,000 income tax bracket, which is 32%, and in the second, your income tax bracket is 24%, with capital gains tax applying to any earnings received from the sale of stock options. The current capital gains on $50,000, for example, is 15% for individuals (excluding the 3.8% Medicare surtax).
Though this is a very simplified explanation, you can see how ISOs could be beneficial for high-income individuals.
There are two types of employee stock option plans:
- Incentive stock options (ISOs): Employees are granted the option to buy company stock at a discount, so they don’t generate ordinary income tax liability, although they could be subject to alternative minimum taxes (AMTs) and capital gains.
- Non-qualified stock options (NQSOs): These are most commonly offered. They’re basically the same as ISOs, but NQSOs may involve some income tax when exercised.
The way you are taxed for your ISOs depends on which of these types you receive. The important thing to remember is that being granted stock options is only an offer. Once the options have vested, meaning the options become available to purchase based on the terms of your employment offer, then you can exercise the option and purchase the stocks. Exercising your stock options is the only way they will have value to you.
This is a complicated topic with a multitude of factors to consider. This is why it’s best to work with a CPA to help you weigh the tax ramifications of your particular situation. Here at Ludmila CPA, we pride ourselves on our extensive knowledge of tax law as it pertains to ISOs, NQSOs, and more.
Let’s say you have been hired on January 1, 2023, by a great public company whose stock is trading at $100 per share. As part of your compensation package, your brand-new employer grants you 100 NQSOs for each of the next four years, totaling 400 shares. This doesn’t mean that you have directly received 400 shares of stock, only that you’ve been granted the option to buy them, and it often involves certain conditions being met, such as working at the company for a certain period of time; these details would be spelled out in your contract.
Usually, there’s a vesting schedule to abide by, such as being available each quarter. In our example, on each anniversary of your hire date with the company, another 100 options will be available to you to be exercised, or “purchased.”
Under some ISO plans, you may have to pay something for those stock options, or at least a portion. The company could give the options to you for free or offer them at a percentage of their value. For example, if you received them for free and you exercise the options when they’re trading at $100 per share, then $10,000 is added to your paycheck on paper, even though the actual amount of cash you take home is the same each pay period. Selling your shares creates capital gains, which are taxed at a lower rate than straight income. That is where ISOs can benefit you.
In some cases, an employer might offer you the option to invest at a discounted rate — for example, at 75% of the value. This is called Restricted Stock (RS). So if the stock is worth $100, your share basis is $75. This is the cost you would deduct on your tax return (and the compensation amount that will be added to your paycheck). When you sell the stock, you will pay capital gains only on the 25% remaining plus any appreciation occurring after the exercise of the RS.
As I said earlier, this is a complicated topic that many struggle to understand, which is why we’re here to help. Before you accept an ISO or make decisions about exercising options or selling stocks, you should speak with a financial advisor and a CPA. But in general, here are some recommendations from us as to what to do with your stocks once you’ve exercised them:
- Hold on to stocks for at least 12 months. By holding on to your stocks for at least a year, you generate long-term capital gains. Selling before that threshold is considered a short-term gain, which is taxed at ordinary tax rates, meaning there’s no financial advantage to you. If you can, try to let them sit there gaining in value for at least year — particularly if the stock is growing rapidly and you don’t have an immediate need for the money.
- Diversify your holdings as soon as you can. The most sophisticated tax-planning clients know that it’s best to diversify your stock holdings so that you aren’t holding stocks only in your company. Obviously, if the company is growing, having many shares in the company is great, but it’s a risk to put all your eggs in one basket. Diversifying your holdings as soon as possible after the first 12 months, as long as no major disruptions to the value of the stock are expected within that year, usually makes good financial sense.
Our team at Ludmila CPA loves talking to clients about tax planning, including the various details involved with ISOs. And since we’re knowledgeable about multistate tax compliance, it doesn’t matter where you’re located; we can still assist you. Contact us to set up your tax planning appointment today!