How do ISOs work?
Incentive stock options (ISOs) are similar to nonqualified stock options (NSOs). A company grants an employee options to buy a stated number of shares at a defined grant price. The options vest over a period of time and/or when certain individual, group, or corporate goals are met. Once vested, an employee can exercise the option at the grant price at any time over the option term up to the expiration date. At that point, the option is said to have "lapsed," and can no longer be exercised.
Unlike NSOs, however, upon the exercise of an ISO there are no ordinary income tax consequences to the employee (though the difference between the fair market value of the stock and the grant price is a tax preference item and subject to alternative minimum tax). An ISO enables an employee to:
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In order to qualify for this favorable tax treatment, there are certain specific conditions that must be met:
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Qualifying vs. disqualifying dispositions
If the holding period rules for ISOs are met, the eventual sale of the shares is called a qualifying disposition. As such, the employee would be subject to lower tax rates for long-term capital gains on the entire increase in value between the grant price and the sale price.
If the holding period rules are not met, the sale would be a disqualifying disposition. When that happens, the entire difference between the grant price and the sale price would be taxable to the employee at higher, ordinary tax rates.*
ISO benefits come with complexity: The AMT
ISOs present the potential for considerable tax benefits, but also complexity in the form of the alternative minimum tax (AMT). With that in mind, a quick overview of the AMT is probably in order here.
The AMT is just what it sounds like: an alternate calculation to your regular tax liability. And as a taxpayer, your obligation is to pay whichever yields a higher amount. If that should be the AMT, then you effectively lose the tax benefit of a whole host of credits and deductions you'd otherwise normally be able to claim.
The original intent of the AMT was to ensure that taxpayers did not make excessive (albeit legal) use of tax loopholes to avoid paying a minimum amount of taxes. To that end, it requires a taxpayer to make a separate calculation which takes account of "preference and adjustment" items that, broadly speaking, fall into 2 categories:
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When ISOs are exercised, the excess of the stock’s market value over its grant price falls into the latter category, and is therefore added along with other preference and adjustment items for the purpose of determining whether the employee is subject to the AMT in that year.
ISOs can potentially provide an alternate source of income for employees who are awarded them. But because of the tax rules that govern them, careful planning is needed ahead of time to maximize their benefit—particularly when large numbers of options are exercised.