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What is an Incentive Stock Option (ISO) and How Is It Taxed?


Sean O’Keefe
Sean O’Keefe

Oct 20, 2020

3 min read
What is an Incentive Stock Option (ISO) and How Is It Taxed?

Most startups enter competitive landscapes when they open their doors, particularly when it comes to talent sourcing. With limited budgets, they’re usually not in a position to compete on salary like established corporations, which is why many new companies offer stock options as an employee perk and retention strategy.

Incentive Stock Options (ISOs) are a common offering by startups that are high growth and want to incentivize their employees to act in the best interest of the company by giving them some skin in the game. This makes them think like an owner. Here’s what you need to know.

What is an Incentive Stock Option?

ISOs are usually offered to startup employees. The ISO is issued on a specific date (called a grant date) and the employee can choose to purchase the stock (exercise the option) at a predetermined price known as the strike price. ISOs usually follow a vesting schedule before employees can exercise their options, although some startups offer the ability for employees to early exercise their shares before they vest. Once the stock is purchased, you can either sell it immediately (public companies), wait for a secondary transaction or tender offer (private companies) or hold onto it.

Tax Obligations for ISOs

ISOs have more favorable tax treatment than other stock options like non-incentive stock (NSO) options or restricted stock units (RSU). However, employees must meet certain holding requirements to receive any tax benefits. When employees exercise their ISOs they need to be aware that they may be taxed when they buy their shares. If you have stock options, chances are you’ve heard about Alternative Minimum Tax. But what exactly is it and how is it calculated? And more importantly, how does it affect your monetary gains? You can find more specific details here.

AMT is calculated based on your regular income minus some personal deductions (such as local or state sales tax). If you have an ISO, you’ll also need to factor in the spread between the price of exercising your ISO and its fair market value (FMV) at the time of exercising.

For example (illustrated above), if the price you can buy your shares at is $1 per share and the current FMV is $5, for the purposes of AMT, the $4 difference between what you can buy them for ($1) and the current FMV ($5) will be used in the AMT calculation to see if you need to pay additional taxes when you buy your shares.

When you sell your shares you may be taxed on capital gains, if the value of the shares have increased since you purchased them.

The taxable amount is the difference between the strike price and price at the time of disposal. As of 2019, you could end up paying anywhere from 0-20% percent on capital gains, depending on your income.

Final Thoughts

ISOs are a special breed of stock that grants the recipient tax advantages, provided that you buy your shares early enough and take the AMT into consideration. You can reduce the amount of taxes you'll pay when you sell your shares if you hold onto the stock for longer than two years from grant date and 1 year from buying them. It’s best to partner with experienced tax professionals that understand the unique needs of startup employees to help you maximize your earnings potential.

Contact us today for help with your taxes, or head back to the blog for more tax insights.

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