For many of Thimbleberry Financial's clients in the startup and tech communities, Incentive Stock Options, or ISO's, are a hot topic. Today, Amy Walls and Jag break them down.
Simply put, an ISO is a type of employee stock option that comes with tax advantages. No income tax is due when options are granted or exercised. Also, profits from the sale of ISO's can be taxed under more favorable long-term capital gains rates, provided certain conditions are met.
In addition to those restrictions around time of holding, Amy also explains the Alternative Minimum Tax, or AMT. When do you pay AMT, and what AMT implications should you consider when exercising ISO's?
We also walk through vesting, expiration, and post termination.
Being proactive and creating a plan is key in this realm; there are certain decisions and actions that cannot be undone. Amy explains the $100k rule and the Rule of 65, and she cautions against being overweighted in company stock, particularly in the context of market volatility.
For more information contact Amy Walls and her staff at 503-610-6510 or click here Thimbleberry Financial.
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Jon "JAG" Gay: Welcome back to ThimbleberryU. I am Jon "JAG" Gay. I'm joined as always by Amy Walls from Thimbleberry Financial. Amy, always a pleasure to be with you.
Amy Walls: Always a pleasure to talk to you. I'm looking forward to our topic today.
Jon: Yes. Today we're diving into the world of incentive stock options, or ISOs. It's the hot topic for many in our tech startup community. I know you work with a number of folks there in Portland in the tech community, and all over, for that matter. We'll start with the basics. What is an incentive stock option, or ISO?
Amy: Simplest definition, it's a type of employee stock option, basically a promise of income if the stock does well that an employer provides to employees. It provides tax advantages to both the employee and the employer.
Jon: How are you eligible for it?
Amy: You're eligible when your employer offers it to you, and then their Board has to approve it. I mentioned some tax advantages of it also. With an incentive stock option, or an ISO, there's no income tax due when the option is granted, and if done properly, meaning not sold, also when it is exercised. Exercise is basically saying, "Hey, okay, you've said I can buy these shares at $10 a share. The stock price is $50 a share. Yes, I'm going to buy them at $10 a share." When you do that, there's no tax due, no income tax due.
Jon: Wow, okay.
Amy: Yes, that's exciting. There is potentially another tax which we can talk about. Profits from the sale of shares acquired from incentive stock options can be taxed as long-term capital gains, meaning preferential tax rates, not income tax rates, provided that certain conditions are met.
Jon: Okay. I have heard, Amy, there's more than meets the eye with those ISOs. What things do people find most surprising about them?
Amy: How the tax treatment works, number one. We get a lot of clients coming to us in the tax sector saying, "Hey, my taxes have been out of control. I don't know what's going on. It doesn't feel like it should be this bad." When we dig into it, they may have accidentally handled their incentive stock options in a way that wasn't favorable.
Let's talk about what does work. To receive this long-term capital gains tax treatment, there's two things that have to be done. First, by the time they're sold, more than two years has to have passed since the grant date, meaning when the employer gave them to the employee, and more than one year has to have passed since the exercise date.
Jon: The exercise date, meaning when they took them up on the offer, essentially.
Amy: Yes, so let's go through this from a timeline. January 15th, 2020, someone was granted ISOs. They were able to exercise them January 16th, 2021. That's a year and one day. That's good. Then they would need to hold them for at least one year, so now we're at January 17th, 2022, to sell and get that favorable tax treatment.
Jon: Two years from when it's granted and one year from when you exercise it. Got it.
Amy: Yes, exactly. Now in the example I just gave, what I didn't take into account there is vesting. Shares vest at different times. What that means is, if I say to you, JAG, "Hey, I'm going to give you $100,000-"
Jon: Cool.
Amy: "-but guess what? I'm going to give it to you $10,000 a year over the next 10 years, and I'm going to start next January," but I say, "Hey, you've got this all now. I've agreed to this. Here you go." It's a little like if you borrowed the money- or if I'd borrowed the money from you and I'm going to pay it back, except there's no borrowing. It's basically a schedule to pay. On set date, this certain number or pool of shares that were given are now going to vest. Once they've vested, you have the ability to exercise them.
Jon: Got it.
Amy: What I always try to remind people of is that until they've vested, they aren't yours, okay? JAG, I may say I'm giving you this money, but until I've actually handed it over, it's not yours. For all our listeners, I'm not really giving JAG $100,000.
Jon: The check is in the mail. My podcast rates just went up. There we go.
Amy: [chuckles]
Jon: Amy, talk to me about the AMT, or the alternative minimum tax. This is something that confuses me.
Amy: It confuses a lot of people, that, [chuckles] so you're in good company. Basically, alternative minimum tax, or AMT, is the government's fancy way of saying, hey, you make too much money and pay too little tax, we think, and so we're going to increase that tax by removing some deductions. The exercising of incentive stock options can trigger alternative minimum tax.
Jon: Can put you over that threshold is what you're saying.
Amy: Essentially, yes. What triggers it is actually the spread, the difference between your exercise price and the market price at the time you exercised option. That's important. It's definitely something that we have to pay attention to in determining, hey, when does it make sense to sell or not?
Another thing that people get caught off guard by is the expiration date. Stock options, non-qualified and ISOs and even RSUs, all have an expiration date, meaning they're only on the book so long. If you have shares, they've vested, you're now able to exercise and you sit and do nothing for quite a while, they will eventually disappear. You actually have to act. It's about figuring out when the right time to act is.
Jon: Like so many things.
Amy: Then one other thing that comes to mind that people really find surprising is what happens when they leave the employer when they haven't exercised. Usually, people have 90 days to exercise those options or they lose them, but they will likely need cash to do so. Whereas when they're employed by the company, they may not need cash. If they don't need cash, there will be more tax consequences, regular income tax for exercising, but the company will often front cash to buy the shares and then take it out of the proceeds. If you've left the company and you're exercising in a 90-day window or whatever window it is the company gives you, you likely are going to need your own cash to buy those shares.
Jon: Got it. Well, as always, Amy, you've done a good job explaining some of the complexities here. If anybody wants further information, as always we'll have them contact- you'll give your contact info at the end of the show. Now that we've got a grasp on some of these complexities, how do we navigate through them?
Amy: Great question. I always talk about financial planning, it's like a puzzle. It's regularly putting the puzzle pieces together. What I mean by that is really proactive integrated advice that's regularly reviewed. Do the puzzle pieces fit together differently today than they did a year ago? If the stock price goes up quite a bit more than what you might expect, how does that change the puzzle pieces? Or if it drops, how does that change?
Jon: Sure.
Amy: I really say proactive because you do need to know what the options are and what the consequences will be. You can't change the outcome once you've exercised or sold.
Jon: Yes, there's no mulligans or do-overs.
Amy: No. It's a good thing little kids don't get these.
Jon: [laughs]
Amy: Just thinking of my kids and, "Can I try that again, Mom?" The right strategy for someone to exercise their ISOs and when to sell their ISOs can be identified based on their overall situation, but that can change.
Jon: Sure.
Amy: We have clients that intend to exercise and sell their incentive stock options based on a strategy that we've worked out together, but then something changes. Maybe their company stock price goes down, and they have restricted stock units, RSUs, on the side, and they emotionally get attached and say, "I'm not going to sell those now," which was also part of the strategy to make the ISOs work. Now they're sitting on a whole bunch more stock, and we've got to figure out what to do. It may be that our strategy for the incentive stock options no longer makes sense.
It may be that we have looked at when to exercise and mapped that out against alternative minimum tax, and the company's stock price drops drastically. Well, in that case, that spread that we talked about for alternative minimum tax is now much smaller, and it might mean that it makes sense to exercise more shares earlier and then hold them the same amount of time or longer. Just depends.
Since we're talking about complexities and essentially, I've answered with, "Well, it all depends on the strategy and it's about realigning strategy as things change," I think it's important that people recognize that not doing something is doing something. It is a strategy, and it may or may not be the best strategy.
Jon: That's fair.
Amy: I think sometimes people think, "I'm not doing anything," when in fact, choosing not to do something is choosing to do something.
Jon: Yes, that's true. We talked about surprises earlier, Amy. Very quickly, what are some of the rules that are often overlooked when it comes to ISOs?
Amy: Yes, two things really come to mind here, JAG. The first is that only $100,000 worth of incentive stock options, based on the stocks' market value at the time of the grant, can become exercisable for the first time in any calendar year. Basically, if instead of $100,000, I had promised you $1 million over 10 years, and I was going to pay you $100,000 each year, and these were ISOs, so that's what's going to vest; that's $100,000 or more, we'd be in trouble, all right? There's boundaries, if you will, in place on how much can be given at any time.
The second thing that comes to mind is the Rule of 65. This is if somebody is 55 years old and has been with their employer, the company whose stock it is, for 10 years and they leave, they may get a longer than the general 90-day window to exercise. That's important. Really, it's helping people be able to retain assets in retirement, if you think about that, but a lot of people don't know that's there. Of course, you have to look at your plan, but most plans have that.
One other thing, now that we're talking, comes to mind. Earlier I talked about, we often see people come to us that say, "I don't know what's going on with my taxes related to all this equity comp. Something doesn't seem right." The thing that can be overlooked is with equity compensation, of which incentive stock options are one form, it's really important that when selling stock, you always sell with lots versus selling shares. If you have 1,000 shares and you're looking to sell the 300 shares you exercised on June 16th, 2020, you can't go in and enter to sell 300 shares in your trading software. You actually need to go sell by specified lot and choose the 300 shares that were exercised that day.
Jon: That makes sense because there's different rules and timeframes around different pieces of that money. That makes total sense. Before we wrap up, Amy, let me ask you about market volatility because that's certainly going to be a factor here as well, right?
Amy: Boy, that's a big topic. We've saved that for the end. Yes, it does impact incentive stock options. As we know, too much of a good thing for any of us isn't such a great thing. It's true for doughnuts, running, and employer stock.
Jon: [laughs]
Amy: With stock, it creates concentration risk. Any single holding that's more than 5% of a person's investments is considered heavily concentrated and then unsafe. When someone is also working for that company, and especially when they are the primary breadwinner in the family, that family's risk just increased dramatically. Market volatility plays a role because stock price goes up or goes down, you get big fluctuations in that.
Liquidity is another thing that is impacted by market volatility. With shares like this, as an employee, you're not in control over when you can exercise or sell. There may be windows when you can sell or exercise, and you don't know what the stock price will be at that time, so you're already limited. You're not 365 days a year and when you can do whatever you want with this stock-
Jon: True.
Amy: -and now the price has gone up and down. Guess what? If you have a window, along with all your coworkers, well, many of them are waiting to get cash out, and so often they are selling in the first day this trading window opens, and the stock price can go down as a result of that trading. Market volatility isn't just the market, it's what's going on with that stock. If you get four trading windows a year, people want their cash.
One way that market volatility can positively impact ISOs, I alluded to earlier. That is that if your stock price has gone down, you may be in a place where you can avoid some alternative minimum tax and actually exercise more shares.
Jon: All right. Amy, for our listeners who have ISOs or they plan to or aspire to have them sometime someday, what's the first step that they should take?
Amy: First, knowledge is power, so get educated, know what it is you're dealing with, and talk with an expert in order to get that. I highly recommend that over trying to gain the information from peers.
Jon: Or worse, the internet.
Amy: Yes.
Jon: On that note, Amy, if somebody wants to come talk to you as somebody who works a lot in this field, what are the best ways to find you at Thimbleberry Financial?
Amy: They can reach us at thimbleberryfinancial.com, or give us a call at 503-610-6510.
Jon: Good stuff, Amy. We'll talk again in a couple weeks.
Amy: Sounds great, JAG. Look forward to it.
Jon: Securities offered through registered representatives of Cambridge Investment Research, Inc., a broker-dealer, member of FINRA, SIPC. Advisory services through Cambridge Investment Research Advisors, Inc., a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated. Discussions in this show should not be construed as specific recommendations or investment advice. Always consult with your investment professional before making important investment decisions.
Securities offered through registered representatives of Cambridge Investment Research, Inc., a broker-dealer, member of FINRA, SIPC. Advisory services through Cambridge Investment Research Advisors, Inc., a registered investment advisor. Cambridge and Thimbleberry Financial are not affiliated.
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