What is an ISO? #
An incentive stock option (ISO) gives you the right (but not the obligation) to purchase your company’s stock at an Exercise Price subject to certain conditions. The date your employer issues the ISO is called the Grant Date.
Grant #
When you receive the ISO, you can’t use it to purchase stocks right away. You still need to wait until the options to vest. On the Grant Date, your employer will determine the Exercise Price (aka the Strike Price) of your ISO.
For the purposes of this note:
Exercise Price = Strike Price
Vesting #
This means that you have to stay with the company for a certain period before you can exercise or use your ISO to buy stocks. Many companies have a four-year vesting schedule with a “one-year cliff.”
A one-year cliff with four-year vesting means that you will only have access to the first 25% of the shares you were granted after the end of your first year and nothing before that. After that, vesting will happen monthly or quarterly with 25% of the ISOs vesting per year.
25% vesting schedules are the norm. However, some firms may have a different vesting schedule, such as, 20% in Year 1-3, and 40% in Year 4.
Exercise #
The Exercise Price of your ISO is the price at which you can buy your company’s stocks after it has vested on a future date. The day you use your ISO to buy the stocks is the Exercise Date.
Early Exercise –> To reduce employee taxes, some companies allow employees to exercise their stock options before they fully vest.
In the case that your employer does permit you to exercise your stock options early and you decide to do it, file an 83(b) election with the IRS in order to verify that you have purchased the options and are claiming it as income in the current tax year (rather than when it vests).
In order to get the benefit of exercising early, you must fill out a simple form and mail it to the IRS within 30 days after exercise. Failure to file this form could result in you owing much more in taxes later and at an inconvenient time.
Taxes #
Pay no tax when you exercise unless you trigger the alternative minimum tax (AMT)
Pay long-term capital gains tax when you sell if the following holding conditions are met (when conditions are met, this sale is considered a qualified disposition of ISO stock):
- Shares are held at least one year after exercising AND
- At least two years after your options were granted.
Qualified Sale
Gain = (sale price – exercise price) x Shares Sold
Disqualified Sale
Short-term capital gains = (Sale Price – FMV at Exercise) x Shares Sold
Ordinary Income tax on (FMV at Exercise – Exercise Price) x Shares Sold
Reporting
Capital gains are reported on IRS Form 8949 and Schedule D of IRS Form 1040. Ordinary income is reported in your W-2
