Incentive Stock Options: How ISOs Work, Compare to NSOs
Knowing the ins and outs of incentive stock options (ISOs) can help take full advantage of this employee benefit.
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You’re an important asset to your company. As such, your employer may offer to share ownership with you by way of incentive stock options (ISOs). But before you can benefit from your ISO, you’ll first have to get to how it works.
What are incentive stock options?
An incentive stock option (ISO) is the right but not the obligation to purchase shares of your employer's stock for a fixed price. The higher the company’s share price goes, the greater the potential reward from the incentive stock options. ISOs get favorable tax treatment.
ISOs are a type of equity compensation granted only to employees, who can then purchase a set quantity of company shares at a certain price. ISOs are often awarded as part of an employee's hiring or promotion package.
ISOs are one type of deferred compensation used to motivate and retain key employees. Since you need to hold on to your ISOs for a period of time, the only way to capitalize on these benefits is to stay with your firm for the long haul.
The higher your company’s share price rises, the greater the reward from your stock options. This encourages high productivity from key employees as they directly benefit from the company’s success.
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ISO vs. NSO: What's the difference?
The main difference between an ISO and an NSO is that ISOs are only issued to employees, and they generally get more favorable tax treatment than NSOs. Taxes on ISOs are typically deferred until you sell the shares, and often only capital gains tax rates apply. On NSOs, ordinary income taxes typically apply when you exercise your options; you also pay capital gains tax when you sell the shares.
ISOs vs. RSUs
The main difference between ISOs and RSUs is that ISOs have an exercise price but restricted stock units (RSUs) do not. With RSUs, the shares automatically become yours upon vesting. With ISOs, you decide whether and when to purchase the shares once your options vest.
RSUs grant employees a specific number of shares, subject to a vesting schedule and potentially other stipulations.
Once RSUs vest, the shares are yours to keep, even if you leave the company.
Typically you’ll owe taxes on the value of your shares when your RSUs vest. The value of your vested shares equals the number of shares times the fair market value of the shares at the time they vest. This value is taxable as income to you, and your company is required to withhold the required taxes.
What is the $100,000 ISO limit?
If the fair market value of an ISO exceeds $100,000, the options may be treated as NSOs, which can change the tax treatment of the options. The rules are complex here and it's a good idea to consult with a qualified financial advisor if you receive ISOs that have or may soon have significant value.
How incentive stock options work
The day your company issues ISOs to you is known as the grant date. At this point, your ISOs are subject to a vesting schedule, or waiting period, until you gain ownership. Once your ISOs vest, you have the right (but not the obligation) to purchase a certain number of company shares at the strike price, which is the fixed exercise price indicated in your ISO grant. You can choose whether or not to exercise your options anytime until your ISO expiration date. Typically, there is a 10-year time frame before expiry.
When to exercise your ISOs
Generally, if the strike price is below the current market price of your company shares, consider exercising your options. This way, you could buy stock at the lower strike price and in turn, sell these shares in the market for a profit.
If the strike price exceeds the current market price, it may not make sense to exercise your ISOs. The company’s shares would be cheaper on the stock market. If the strike price never goes below the market price, your ISOs could expire worthless.
The difference between your strike price and the market price when you exercise your ISOs is often referred to as the "bargain element."
How to exercise your ISOs
When exercising, you don’t always have to purchase the shares with cash. You could potentially opt for a stock swap — if your employer offers it — where you’d exchange the company shares you already own to get more shares.
Here’s an example: You can purchase 1,000 shares of company stock at $20 per share with your vested ISO. Shares are trading for $40 in the market. If you already own 500 company shares, you can swap those shares (500 shares x $40 market price = $20,000) for the 1,000 new shares, rather than paying $20,000 in cash.
Alternatively, you might be able to borrow the funds needed to exercise your ISO from your broker and then sell at least a portion of the shares to cover your costs. This is called a cashless exercise, and while it has its advantages, it also disqualifies you from the favorable tax treatment discussed below.
However, you don’t have to exercise your ISOs and immediately sell. You can hold on to your unexercised options until closer to expiry or exercise your ISOs and hold on to the stock indefinitely, especially if you believe in your company’s future prospects.
How do you know which option is best or how long to hold for? Much of the time, it depends on the tax consequences.
How are ISOs taxed?
ISOs have tax advantages, but there are requirements to follow in order to gain the greatest benefit.
Favorable tax treatment
ISOs aren’t taxed when granted, upon vesting or when exercised. Taxes are deferred until shares are sold, and if you meet certain holding requirements, ISOs are subject only to capital gains taxes. This differs significantly from NSOs, which are taxed upon exercise at income tax rates and then again with capital gains taxes when shares are sold.
Holding period
After exercising your ISOs and purchasing shares, waiting over a year from the exercise date and at least two years after the grant date means you’ll meet the requirements for a “qualifying disposition.” This means your transaction will become eligible for preferential tax treatment, and you’ll only owe long-term capital gains taxes.
Selling your shares before the holding period ends generates a “disqualifying disposition” and will likely subject you to paying ordinary income taxes on the bargain element as well as short-term capital gains taxes .
Alternative minimum tax
Although you can achieve favorable capital gains tax treatment on your ISOs, the bargain element earned must be reported as taxable compensation and may trigger alternative minimum tax (AMT). This tax ensures that certain high-earning taxpayers pay at least a minimum level of income tax.
ISO caveats to keep in mind
Holding period risk. Waiting to satisfy the “qualifying disposition” requirements makes sense from the tax perspective. However, the stock could fall during this time and negate the value of your stock option.
Concentrated stock. Diversification spreads your investments across various asset classes to reduce risk and balance volatility. As such, it’s important to ensure you’re not overly exposed to your company’s stock to help minimize risk in your overall portfolio.
AMT payment. If you trigger AMT, payment could be problematic. You could get stuck paying your alternative minimum tax bill before you sell the stock, meaning you wouldn’t be able to use the proceeds from the sale to cover your tax payment. It may be a good idea to consider exercising ISOs earlier in the calendar year so you have time to accumulate funds and manage your AMT liability. You could also consider avoiding AMT by selling the shares in the same year you exercised them. For example, if the price of your company shares falls after exercising your ISOs, it may make sense to sell the shares in that same year. Although this would generate a disqualifying disposition and cause the bargain element to become taxed as short-term capital gains, it might prevent you from triggering AMT and could reduce your tax burden.
Tax withholding. Since taxes aren’t due until shares are sold with ISOs, your employer does not need to withhold taxes on your behalf. It’s important to consider the tax liability and set aside the funds required in preparation for selling your shares.
Departure from employer. If you separate from your employer but have vested ISOs, keep in mind that you typically have three months to exercise them to maintain their ISO status. After this time, your ISOs convert into NSOs.
$100,000 ISO limit. An employer is limited in the amount of ISOs it can grant to each employee during any calendar year. If the fair market value of the stock exceeds $100,000, the options above the limit are treated as NSOs.
How to get help with your ISOs
If you receive ISOs as part of your compensation, the hope is that over time, your company’s share price will appreciate well above the strike price. If this happens, exercising your options would mean the ability to sell for a decent profit. However, taking advantage of your ISOs means taking on complex tax scenarios. Working with a wealth advisor who can analyze your overall financial situation could help you exercise your ISOs and sell your company’s shares at the most opportune time.
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