How to assess your incentive stock option (ISO) strategy

This article was first published by Forbes

Getting paid by your employer should be easy, right? I’m sure half of the people reading this article have never even had to bring a paycheck to their bank and actually make a deposit. However, in this article, I wanted to dive into some situations I have been helping my clients with lately that turn that concept on its head – equity compensation.

Equity compensation plans are complex animals, as various tax considerations (depending on vesting schedules), IRS elections, and how you monetize the options can all impact the financial outcome. As one of the most complicated equity compensation plans, the incentive stock option (ISO) keeps people up at night as they work through “What if?” scenarios, grapple with taxation concerns, and assess the possibilities.

Using ISOs, employees can acquire shares of company stock at a discounted rate and potentially receive tax breaks on the profits generated by the sale of that stock. Once sold, qualified ISOs are taxed at the current capital gains rate (zero to 20%, depending on income level) versus the ordinary income rate. (Non-qualified stock options, or “NSOs,” are taxed as ordinary income.)

Now comes the hard part: Once exercised, ISOs are billed as “tax-free” exercises, and as long as employees meet certain requirements, they only pay capital gains tax when the stock is sold. But there’s a catch: Once exercised, a qualified ISO generates an alternative minimum tax (AMT) consequence.

AMT is a second set of tax calculations that can apply to every individual tax return in theory, whether you realize it or not. Put simply, AMT disallows or recalculates various income items or deductions used to determine your adjusted gross income (AGI) to come up with an alternative minimum taxable income (AMTI). After that, you utilize an exemption amount (to keep this from affecting low-income taxpayers) to get the final AMT calculation. Qualified ISOs create additional AMTI for the difference in the fair market value of shares exercised and the amount actually paid by the employee.

Amid reports of climbing tech valuations and high interest in life sciences M&A, more individuals will likely be assessing their existing ISOs and coming up with a game plan for either retaining or exercising those options. As someone with career experience as a public accountant working with tech and life science companies, I’ve helped many individuals work through these ISO-related issues and develop strategies to maximize their potential benefit.

Proposed changes to the capital gains tax rates could reduce this benefit, so I advise carefully considering your choices and consulting with your tax advisor before taking action. But I’ve come up with five key points that individuals can use to navigate the nuances of ISOs. They are:

1. The earlier you exercise an ISO, the more value you could get out of it. If you consider your AMT tax bill as an “investment” in your future tax savings (in the form of a tax credit), the more the stock grows between exercise and sale, the higher your rate of return on that investment will be. Putting it off may be somewhat of a gamble in that you don’t really know how much a small startup company will be worth in two to three years.
2. Depending on your AMTI, exercising your ISO could be a tax-free event. Even if you have items that are only taxable for AMT purposes, you could find yourself in a situation whereby you can exercise the ISO on a tax-free basis because adding to your AMT income doesn’t necessarily always increase your tax bill. Thanks to the exemption mentioned earlier, as well as the difference in tax rates between AMT and the regular tax calculation, higher AMTI does not always mean a higher tax bill.
3. Just because you exercise your ISO doesn’t mean you won’t be involved in the company’s success. Unlike a nonqualified stock option, where the employee may need to cash out to cover most of the tax bill, ISOs can make it easier for you to continue to participate in the growth of the company. If you can hold the stock after you exercise the ISO, your position as a shareholder will remain intact.
4. If a change-of-control event occurs, the ISO may be treated as “nonqualified” if you’re required to immediately exercise and then sell your ISO. A merger, consolidation, reorganization, or similar transaction can impact your ISO. If this happens, the full value of the ISO will be taxed as ordinary income when it’s exercised. In order to receive capital gains treatment, the employee must hold their stock for a year after the exercise. The earlier you exercise, the sooner that timer starts.
5. If the company is a qualified small business (QSB), exercising starts the clock for Section 1202 qualified small business stock purposes. When you exercise your ISO and hold the stock, the clock starts on a five-year holding period to qualify for Section 1202. This essentially means that even when you sell the stock, you can potentially exclude up to $10 million of gains on the sale of a single company’s stock when you sell it. The stock has to qualify for this treatment, and you’ll want to consult with a qualified tax advisor on how to handle this, but one major requirement is that you have to hold onto the stock for five years.

Because I’ve worked in and around ISOs for years, I can tell you that that decision is like anything in life: If you don’t make the decision to exercise it at the right time – for example, when the company’s valuation is still relatively low – doing it at a later date may be prohibitive based on the potential tax implications. As values go up, the appeal of exercising an ISO may lessen because the alternative minimum tax burden can make it more difficult to exercise and hold the stock – versus just cashing out at ordinary income tax rates.

_{Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.}