How Your Incentive Stock Options (ISOs) Work: Your Guide To Avoiding Pitfalls
“Chase the vision, not the money; the money will end up following you.”
–Tony Hsieh, Zappos CEO
Today I’ll go through a case study to illustrate how your Incentive Stock Options work in order to empower you to maximize their benefits and avoid any potential pitfalls.
As our friends and clients in San Francisco navigate these career transitions they’ve discovered that the variety of employers they work for, and a company’s growth during their time there, can have significant implications for their wealth. In the Bay Area, the choices you make as a start-up employee around your stock options affect whether and how much it costs you to keep stock when you leave the company as well as how you are taxed on your stock options.
Companies often distribute stock to their executives and employees through Employer Stock Purchase Plans (ESPPs), Non-Qualified Stock Options (NQSOs), or compensation through Restricted Stock Units (RSUs). These forms of compensation are outside the scope of today’s discussion. Instead, we will focus on Incentive Stock Options (ISOs.)
Most start-up employees are given Incentive Stock Options that usually vest over four years of employment, with an initial one year cliff. Today I'd like to clarify for you how ISOs work, and how to maximize their benefits while avoiding costly mistakes. I would like to help you proactively understand your stock options so that you can maximize their benefits.
The Lingo
Some of the confusion around ISOs happens because the terminology is confusing. Let’s start there, with some brief definitions.
Stock Option: The right to purchase a company’s stock for a specific price.
Vesting: The date on which you have the choice to purchase your option and own company stock.
Strike Price: The price at which you get to buy the company’s stock.
409A Valuation: A 3rd party’s valuation of your start-up’s company worth. This valuation occurs at least as often as each round of funding.
Alternative Minimum Tax: An alternative way the IRS calculates your tax due. AMT may be triggered when you exercise your options if the stock price is valued above your strike price.
Let’s cover 409A valuations in a little more depth. Basically every time a company raises VC funding or goes through a variety of other possible changes the valuation of the company may change and the underlying stock of the company is calculated again by a 3rd party. While an employee’s strike price (purchase price) never changes, the value of the stock itself does change. We’ll see how this affects options owners in our examples.
Our Case Study
For the remainder of this post I will use a hypothetical example to cover a few possible scenarios. We’ll call our subject Jackie Sandberg, working at Rockpile start-up.
We will look at three different ways Jackie can deal with her options. She can A) exercise her options as they vest - basically buying the underlying stock as soon as she has the right to do so; B) exercise her options after a sale or IPO; 3) elect not to wait for the options to vest, but to leave the company before it IPOs or is sold. Each of these scenarios has implications for her tax strategy and wealth planning.
Scenario One: Purchasing as Options Vest
Upon joining Rockpile Jackie was given 50,000 options with a strike price of $0.40. After year one Jackie has vested one fourth of her options, or 12,500 shares. If the company hasn’t gone through another round of funding, and no new 409A valuation has been made she can buy those 12,500 shares for 40 cents each (12,500 x .40= $5,000). She is now the proud new owner of 12,500 shares of Rockpile stock.
The next year she chooses again to exercise her last 12 months of vested options. But this year the company raised a significant amount of funding with high hopes for a large IPO. A new 409A valuation is completed and the underlying stock is now considered to be worth $3.00/share. The stock she is buying the second year is thus worth 12,500 x $3.00 = $37,500. Her strike price, however does not change. So she gets to purchase another 12,500 shares for $5,000 just like she did the year before.
No ordinary income tax is triggered by her purchase. But this is where the Alternative Minimum Tax might come into play. The difference between her cost of $5,000 and the appraised fair market value of $37,500 ($37,500 - $5,000 = $32,500) is considered taxable and must be reported. Yes, Jackie might incur a tax bill before she even has a chance to sell her stock.
For the next two years Jackie can continue to decide to exercise her options as they vest, or decide not to do so. But, whether she stays or leaves her company she owns her purchased stock.
To end this scenario let’s discuss Jackie’s last need: selling the stock for what we’ll assume is a profit. When selling her stock to receive the best possible tax treatment she must satisfy a holding period requirement. If the sale is at least two years after the grant date, and one year after the exercise, the gain is treated as a long-term capital gain instead of ordinary income tax. So by purchasing her options she gives herself both the earliest possible opportunity to sell her stock with the lower long-term capital gains tax rate.
If Jackie sells her stock for $100,000 in 5 years on the open market, after having paid $10,000 for it, she gets the favorable long-term tax rate on the growth of $90,000. While she may have paid AMT on the difference between the fair market value and her strike price, that does not step up her basis to the fair market value. Instead she may have earned an AMT credit, which could allow her to recoup the AMT tax she paid down the road. How this works out in practicality is very case specific. We won’t dig into it here, but just know that Jackie is not getting taxed twice on her gains.
Finally, it’s important to note that if Rockpile’s value goes to zero, her purchased stock’s value also goes to zero. By exercising her options, Jackie is putting money behind her belief that the company is going to grow and succeed.
Scenario Two: Waiting to Exercise Until after IPO or Company Sale
In our second scenario Jackie decides that she wants to wait to exercise her options until after her company is bought or IPOs. If the company fails, the cost to her is nothing because she never purchases the stock. But if the company succeeds her cost to purchase her options could be much larger because of her tax liability.
In this hypothetical scenario she holds on to all her vested options until IPO. Her 50,000 shares end up being valued at $20/share when the company IPOs. She can purchase all her vested options for $20,000 (50,000 x $0.40 = $20,000). But her AMT tax liability is going to be based on the difference between her price and the fair market value. $1,000,000 - $20,000 = $980,000. In this situation she will probably have to sell some of her stock to be able to pay the incurred taxes. But for her to have her sale qualify for long-term capital gains rates she would still have to satisfy the holding period. As you can see, balancing the potential tax burden of options can get tricky quickly.
While her company may give her the opportunity to take a “cashless exercise” where some of her shares are traded in to cover the tax bill, her gain that year will still put her in a high marginal tax bracket.
Scenario Three: Changing Employers
In our last scenario Jackie decided that she didn’t want to exercise her options as they vested, but after 3 years of being at the company she receives a job offer she decides she can’t refuse. She leaves for the new job, and starts to wonder what will happen to her options at Rockpile. After calling Rockpile’s HR she realizes that she has 90 days to exercise her options (this is a standard timeframe for start-up option expiration). She can purchase the vested portion of her options ¾ of 50,000 for the strike price of $0.40/share. But in Jackie’s case there has been a recent 409A valuation and the fair market value is $4.00/share. So while she only needs to pay $0.40 x 37,500 = $15,000 to purchase the stock, her AMT tax liability is going to be based on the difference between her cost and the fair market value: $37,500 x 4.00 - $15,000 = $135,000.
In those 90 days she has to determine whether she is willing to take on the AMT obligation. Since the company is not yet public, she cannot easily sell her shares once she purchases them. One of the most difficult pieces of decision making is the fact that just because an employee or former employee owns stock, it does not mean they can sell it. Privately held companies have protocols for when and if their stock can be held, and even when a company goes public employees are almost always subject to a lock-up period before they can sell. This conundrum of owing tax before a person’s options are easily disposable on the open market is a real challenge that tech-employees often face as they transition from one company to another.
Conclusion
So what should Jackie do with her options? And more importantly what should you do with yours? The simple answer is that it depends, because developing a plan for your options depends on multiple factors, some of which are in your control (like when you purchase your options, how your compensation is structured), and some that aren’t in your control (like whether your company rockets to success, the liquidity of your stock, and the U.S. tax code).
We hope that this discussion has helped give you a better grasp on how Incentive Stock Options generally function. Ultimately, options can be a fantastic way of participating in your company’s success. But there are plenty of moving parts. We wish you the best as you plan for your future. If you’d like help wading through them we’re here to help.
Additional Notes
You mentioned an AMT tax credit, what’s that all about?
Let’s dive in a little deeper to how the AMT works. Basically, every year your tax liability is calculated using two different systems, the regular system, and the AMT. You pay whichever is higher.
By example, if in Year A under the regular tax system you owe taxes of $39,000, and under the AMT calculation you owe $33,000, then you’ll pay $39,000. On the other hand, if under the regular calculation you owe $33,000 and under the AMT calculation you owe $39,000 you’ll pay $39,000, and get a $6,000 AMT credit.
This credit can be applied to lower your taxes in years that you aren’t subject to the AMT, and bring your regular tax rate down to what you would owe under the AMT calculation.
So, if in YEAR B you owe $40,000 under the AMT system, and $44,000 under the regular system, you can use $4,000 of your prior year credit to bring your tax back down to just $40,000, and carry forward the additional $2,000 to your next return.
Key Takeaways:
a) Exercising your stock options in small blocks may allow you to avoid AMT all together, and benefit from long-term capital gains from the stock sale.
b) It is imperative that your tax preparer tracks your AMT credit every year (using form 8801 – Credit for Prior Year Minimum Tax).
c) If you are subject to AMT, or have been in the recent past, please don’t file your own taxes using Turbotax, or any other do-it-yourself tax software. You’ll want to get this right, and you’ll want to carryforward potential AMT credits to future years. Please. Just. Don’t.
What about state income tax, or state AMT?
Yes, California has its own AMT of 7% which has its own exemption limit and phase-out amounts. Unfortunately, if you’re liable for both the federal and state AMTs, you could be on the hook for a 35% tax rate on exercising your options (7% CA+ 28% federal).