THE DUFF TORNEY TEAM

Michael Torney, CFP, J.D., LL.M. 

Incentive Stock Options (ISOs) are the right to buy shares of company stock at a fixed price; this price must not be lower than the actual fair market value of the stock. Executives who receive ISOs have the opportunity to receive a tax benefit once they sell their shares. Because of the potential savings involved, it’s important to determine when to exercise and sell your shares.  

ISOs are one form of compensation often awarded to executives to retain them while providing an incentive to generate increased revenues and profits. They are usually issued by publicly-traded companies, or private companies planning to go public in the future. These awards require a plan document that clearly outlines how many options are to be given to which employees.  

How Incentive Stock Options (ISOs) Work

Stock options are granted at a price set by the employer called the strike price. The grant date is the day the ISOs are issued.  ISOs require a vesting period before they can be exercised. The employee must exercise their options within the window defined in the plan document (at most within 10 years of receiving them).  After the shares have vested, an executive can exercise their options and either sell the stock immediately or wait for a period of time before doing so.  

ISOs have unique tax benefits compared with other equity-based compensation methods, such as non-qualified stock options or restricted stock units. The first benefit is that you do not have to include any amount in your regular taxable income when exercising your options. 

However, one of the more attractive features is the ability to be taxed as a capital gain vs. ordinary income. The difference can be material. As of 2023, the maximum federal long-term capital gains tax rate is 20 percent (plus 3.8% net investment income tax). On the other hand, the federal ordinary income tax rates for individuals ranges from 10% to 37%, with many executives falling into the top range (in addition, wage income is also subject to Social Security and Medicare taxes, which we will ignore for simplicity).  State taxes may apply to both capital gains and ordinary income depending on the state. 

To qualify for the federal long-term capital gains tax rate, the shares must be held for more than one year from the exercise date and two years from the option grant date. 

Finally, there can also be alternative minimum tax due at exercise depending on the tax payer’s situation. 

Waiting One Year Can Provide Significant Savings

Let’s look at an example. A company grants an executive 5,000 shares at $10 per share on February 1, 2023. The plan document states the employee may exercise the option and buy the 5,000 shares after February 1, 2025.  The employee exercises the shares on February 1, 2025.  The executive is in the highest federal income tax bracket. 

If the stock price of the company is $25 on February 1, 2025, the value of the executive’s shares is now $125,000.  If he or she sells right away, their gross profit is $75,000.  Once federal income taxes of 37% are deducted, the net profit could fall as low as $47,250. And it could be lower if state income taxes apply. 

If the executive waits until February 2, 2026 to sell the shares, the gains are taxed as a capital gain – a maximum of 23.8% percent (in 2023) – vs. a 37 percent income tax rate if they sell as soon as they exercise their shares. 

In addition, by waiting until February 2, 2026, the net profit could be significantly higher.  Assuming the company’s stock price has increased to $30 per share, the value of the shares is now $150,000. The gross profit is $100,000. By paying a capital gains tax of 23.8 percent, the net profit is $76,200 – $28,950 more after-tax profit compared to cashing in the previous year.     

There is some potential downside from waiting to sell your ISOs. If your profits are large enough, it could trigger the federal alternative minimum tax (AMT). The AMT applies to individuals with higher incomes to ensure they pay at least a minimum amount of tax. A financial advisor can help you determine various tax scenarios so that you can maximize the amount of profit from any ISO sale.  Another downside – the stock price could go down from the vesting date and the date where capital gains apply. 

Every executive needs to evaluate their needs and how ISOs fit into their overall financial plan. If you have recently received or currently hold Incentive Stock Options and would like to discuss how to maximize the value of these awards, contact our team at DuffTorneyteam@monetagroup.com. We work with many executives and offer a free consultation on how a comprehensive financial plan can help you build financial independence. 

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