Stock Options – ISO tax implications – Benefit or Burden?

By Jonathan Laddy:

As a company, you intended the stock options you provide to be a benefit not a burden to your employees.  For the employee to obtain the maximum benefit from the options, they have to be able to exercise the shares.  However, the tax implications of the exercising ISO (Incentive Stock Option) shares can have costly consequences for your employees.

Here are some tax implication scenarios that can transform ISOs from benefit to burden:

At the date of Exercise:  When an ISO is exercised, there is no regular tax consequence.  However, there are implications for Alternative Minimum Taxes.  The difference between the Fair Market Value (FMV) and the exercise price is a tax preference item in computing AMT tax liability.  The implication of this can be significant and needs to be understood prior to exercising.

For example, the employee may have a significant tax liability without having the ability to sell the stock (or a decrease in share value occurring after the date of exercise), resulting in a tax liability without the corresponding cash to pay the bill.  This situation can be disastrous when the exercise happens in one year and a decrease in value occurs the following year.

Sale of ISO Shares:  If the ISO shares are sold after at least two years from the date of grant and one year from the date of exercise, long-term capital gain rates apply.  This is a significant advantage of the ISO plan.  However, if the shares are sold prior to the one year period, a “disqualifying disposition” has occurred and the gain is ordinary income and is reportable on the employees W-2.

For many employees to be able to afford to exercise and to pay the corresponding / associated taxes, a sale of at least some of the shares may be required, but problems can arise when a market is not available to the shareholder (ie restrictions of the transfer of shares in privately held companies).  In such a case, why wouldn’t the employee just hold the options?  Well, they might be leaving the company; or for long term employees, the options might be expiring (10-year max period for ISO’s).

Solutions:

In a situation as described above, a combination of bonuses and partial sales may be structured in ways to ensure that your valuable long-term employees are not in a position where they have to make a decision to either incur significant tax burdens or simply walk away from their ISOs .

This is the second post in a series of posts regarding stock options and other equity plans.  Here is the first post on, Equity: A Strategy for Recruiting and Retaining Talent.