Incentive stock options (ISOs) are often part of executive and key employee compensation packages. But these incentives have to be handled carefully to get the most out of them.
“Rules for reporting ISO transactions, and for all types of stock options, are fairly complicated,” said Robbin E. Caruso, a CPA, partner and co-leader of the national tax controversy department at Prager Metis in Cranbury, N.J.
ISOs are issued at a “strike” price per share set by the company; employees typically must complete a vesting period with the company before they can buy shares in an ISO. Employees can then sell the shares later for the their current price, which could be much higher than the strike price.
For the best tax benefit, the employee must sell their position at least one year after exercising the stock and two years after the grant. This is known as a qualifying disposition. “At this point, the taxpayer generally recognizes no income for regular tax purposes and the net investment income tax doesn’t apply upon the grant,” said Christi Gallagher, a CPA and partner at Friedman LLP in Marlton, N.J.
“If the employee who exercised the ISO doesn’t hold the [shares] for one year and a day, the gain is recharacterized as ordinary taxable income,” said Timothy Speiss, a CPA and partner-in-charge of accounting firm EisnerAmper’s Personal Wealth Advisors Group in New York. This is a “disqualifying disposition,” and the income shows up as fully taxable.
“Most important is knowing your cost basis in the options, plus when the options vest and when you can sell and get capital gain treatment,” said Brian Stoner, a CPA in Burbank, Calif.
If harvested properly, ISO profits aren’t subject to ordinary income tax at exercise but may be an add-back item for alternative minimum tax purposes (AMT).
“ISOs’ tax ramifications can be more favorable than other types of stock options, such as nonqualified stock options and restricted stock units, which are generally subject to Social Security/Medicare taxes and ordinary taxes,” said Jennifer Li, a CFP and enrolled agent and financial planning manager at EP Wealth Advisors in West Los Angeles, Calif. “Many high-net-worth clients do tend to have some understanding of the tax complications of ISOs and other aspects of their compensation, but they may be uncertain of the nuances and the approach of how to exit the position in a tax-efficient manner.”
For tax planning, “be aware of the dates when the sale of the options would generate preferential tax treatment. Taxpayers may also want to plan to harvest losses to offset any ISO gains,” Gallagher said. “Additionally, with the impending change in [administrations], there’s a high probability of increased tax rates, including long-term capital gain tax rates, for wealthy individuals.”
This year’s AMT rate is estimated now to be 28%, Speiss said. The current top regular income tax rate is 37%, but President-elect Biden proposes bumping that to 39.6%.
Vesting and holding periods do create some risk to the employee, as the value of the shares may decrease from the grant or exercise date. The employee often has up to 10 years before the granted ISOs expire.
“If taxpayers are subject to [AMT], plan for the cash needed to cover both the exercise cost and the AMT,” said Beth Gaasbeck, a CPA and senior tax manager at Drucker & Scaccetti in Philadelphia. “Taxpayers can plan to exercise in a tax year when they expect their income to be under the AMT exemption phase-out threshold.
“It’s important to stress [timing] to clients who may be tempted to sell based on current market conditions or cash flow needs,” she said.
Charitable-minded clients can also consider giving ISOs that have qualifying dispositions to a donor-advised fund. This “can help you not only avoid the capital gains recognition but also receive a tax deduction on the fair market value if you itemize your deductions,” Li said.