Incentive Stock Option (ISO) Planning
Incentive Stock Options (ISOs) are a unique form of equity compensation that are primarily governed by Internal Revenue Code Section 422. ISOs provide attractive ownership opportunities for key employees of companies, yet with these opportunities come significant investment, tax, risk management and liquidity planning needs. Focusing on, or only understanding, one area of the many ways ISOs can permeate your financial world can result in a less than ideal overall outcome. There is a certain temptation and feeling of exclusivity to having ISOs, but “more” is not always “better” here unless a true understanding of these unique options exists first. Let’s take a deeper dive into what exactly ISOs are and some of the fundamental planning considerations that most commonly apply to employees that hold and exercise these options.
What are ISOs?
ISOs are rights issued by a company to an employee to buy company stock at a specific price over a specific period of time. They are commonly issued in pre-IPO companies or startups and to certain key executives in public companies. Typically the price at which the stock can be purchased by the option-holding employee must be equal to or greater than the fair market value of the issuing company’s stock at the day the rights were granted. In some cases, the grant price must be even higher for certain 10% or more shareholders.
The basics of ISOs are fairly straightforward. If you have one ISO, equivalent to one common share when exercised, granted at $2 and the current market value of your company stock is $5, you are able to acquire one common share worth $5 while only having paid $2 to acquire. As prices rise over time and more and more options to purchase shares are involved, the long-term potential benefits become more clear. Navigating how to best realize those benefits into true wealth is much more difficult.
ISOs have inherent tax implications that can result in large liquidity needs depending on each individual’s tax situation. Exercising an ISO does not result in a regular tax liability, however an adjustment to a taxpayers alternative minimum taxable income does occur. Once shares have been received from exercising an ISO, the shareholding employee can potentially qualify for long-term capital gain treatment if they do not dispose of their shares until more than one year after exercise and two years since they first received the grants that were exercised to acquire said stock. This is referred to as a qualifying disposition. More on this and tax considerations of ISOs further below.
Employees that receive ISOs are typically subject to a vesting schedule. This means, an employee may be granted 1,000 ISOs of their company, but may vest (receive the right to exercise the options) over the course of several years. Perhaps 20-25% vests after one year of service after grant, with the remaining balance vesting on a monthly basis thereafter - this is a common vesting structure. Any employee can only exercise an option if they are fully vested, and an employee can only be fully vested if they meet certain time or performance metrics, depending on the ISO plan. If an employee were to leave a company, they would generally not receive their unvested balance of ISOs and would also have approximately 90 days from their separation of service to exercise their vested ISOs before forfeiting the special ISO classification and treatment.
Investment Planning with ISOs
ISOs can be attractive from an investment perspective as they allow an employee to gain equity in their employer while paying less than fair market value. Prior to exercising options on price consideration alone, ideally an ISO holder has assessed their overall investment portfolio and how company stock fits within this plan. While it can be tempting to acquire as much company stock as possible (as quickly as possible), without proper planning an employee can become unnecessarily over concentrated in company stock. This results in single stock risk and wide variability in overall wealth. You already work for and are paid a salary by your company, be thoughtful about how much more of your wealth you want to tie up into equity at any given point in time.
One attractive investment consideration about options in general is the investment leverage they offer. For example, a $1 grant price for a company with a current fair value of $3 is a profitable position, but not necessarily as attractive as if the same company may have a future fair value of $5 if you still only had to pay $1. The higher the fair value of the company, the more leverage the options offer (acquiring more value for less cost).
Now, this does not necessarily mean someone should only hold options until they near expiration, hoping a stock continues to go up until the day before expiration - this would be foolish and we would argue is not a true plan. However, if the stock price is intended to rise over time, absent other planning considerations, it can be worthwhile to develop a plan and strategically exercise over a period of time, rather than all at once or exclusively over only a one or two year period. Of course, all situations are different and should be analyzed on a stand-alone basis.
An important investment truth when it comes to dealing with all forms of company stock plans - not just ISOs is that employees may have biases and beliefs that their company will continue to excel into perpetuity. This simply is not the case for all companies and certainly not true for all ISO holders. The market is unforgiving and without proper understanding of the investment fundamentals of your company, any long-term benefit may be luck. While over long-periods of time, investment markets tend to appreciate, this is not necessarily the case for individual companies and their stock. We strongly encourage ISO holders to work with a qualified advisor to help develop a plan on when and how many ISOs are wise to exercise over time.
Tax Planning with ISOs
One of the very things that sets ISOs apart from other traditional Non-qualified Stock Options (NSO or NQSO) (which are more commonly issued) are the unique tax implications.
When an ISO holder decides to exercise their right to acquire company shares in exchange for a set price, a regular taxable event has not occurred. What they have done however is created a potential alternative minimum tax (AMT) liability.
For example, assume John Doe exercises 10,000 fully vested options of ABC Corp with a grant price of $2 and a current fair value of $10. John is required to provide $20,000 worth of value ($2 * 10,000) to acquire shares worth $100,000 ($10 * 10,000). Sounds like a no-brainer. However, John must also make an AMT adjustment in calculating his taxes for the spread between the grant price and fair market value. In this case, $80,000. This $80,000 adjustment increases the likelihood that John will be exposed to the alternative minimum tax and potentially face a large income tax liability.
Following the 2017 Federal Tax Reform, less taxpayers are likely to be subject to AMT. This is generally a good thing for ISO holders. However, those with large AMT adjustment items, such a large ISO exercises, are more likely to be subject to AMT and have potentially large tax liabilities. The more ISOs an employee exercises in a given year and the larger the spread between grant price and fair market value, the higher the likelihood of being subject to the alternative minimum tax (absent other tax activity). If exercising ISOs does result in AMT exposure, while there is an inconvenience in paying tax up-front, a taxpayer does receive a minimum tax credit to offset regular tax in future years they are not in AMT.
If a taxpayer exercises ISOs without incurring AMT they have been able to successfully avoid taxation until they eventually sell their shares. Developing a plan where the appropriate amount can be exercised each year, over time, while avoiding AMT may be ideal for many. This may be able to be accomplished with well-coordinated financial and tax planning.
After exercising, if a shareholder holds those shares for two years from grant (when they were granted the options) and one year from acquiring the shares (when they exercised the options), any subsequent sale qualifies for preferential long-term capital gain treatment. If these criteria are not met, a disqualifying disposition has occurred and a potentially less desirable tax outcome may result, subjecting the taxpayer to higher tax rates.
In reality, an employee often has several tranches of ISOs with varying grant, vesting and expiration dates as well as differing grant prices. This typically results in the need for a coordinated plan that takes into account the impact of staggered taxable events over time. Further, when an employee has been granted ISOs, they may also possess NSOs which have entirely different tax implications.
Liquidity Planning with ISOs
Even if you may determine that from an investment and tax perspective, exercising some ISOs makes sense, proper liquidity must be planned for to pay exercise prices and taxes. In order to acquire shares, cash is often required to pay the exercise cost. In some cases, the employee may be able to partake in a cashless exercise and receive a net-number of shares by using some of their existing grants as value rather than providing cash. Even then, unlike with NSOs where tax withholding on the difference between grant and fair value prices is withheld from an employee’s paycheck, an employer is not required to do this for ISO exercises. Namely because ISO exercises do not result in regular income tax (only AMT - see above). Therefore, the employee (you) is solely responsible for understanding whether cash may be needed to pay AMT.
It is crucial to ensure proper cash needs are met to be able to make required payments associated with exercising ISOs without throwing the rest of your financial plan off track. If a large portion of your available liquidity and capital is required to pay costs associated with ISOs, you may be over-extending yourself beyond your means. Further, if this is true you are likely acquiring too much of your company stock, too quickly.
Many ISO holders are those at pre-IPO or younger companies as these awards may have been a strategic plan by management to allow for (and incentivize) early or key employees to share in the company’s upside while minimizing the company cash outflow. As a result, there may be blackout or restricted periods surrounding an IPO in which the stock can not be sold. Even absent an IPO event, there may not be a highly liquid market of willing buyers. Even for those in management or key roles at large public companies that have acquired shares through ISOs are often subject to restricted selling plans and trading windows.
Without proper cash management and liquidity planning consistent with a broader financial plan, even those with very lucrative ISO and other equity compensation awards can run the risk of overextending themselves and hit a liquidity crunch.
By now we see that ISOs have a variety of complex and interrelated rules that must be navigated to derive as much wealth as possible from them. They are a fantastic planning resource but are often not managed or understood properly to maximize their full benefit. At Hudson Oak Wealth Advisory our advisory team has years of experience working with ISO holders at all points in an option holder’s life-cycle.
In the end, what are the key things to remember before jumping into the deep-end with your ISOs?
Understand the investment risk you can tolerate. Then ask yourself how much, if any, of this company stock fits into your overall investment plan. Single stock positions come with inherent risks and even the most trustworthy companies will undergo periods of volatility or under-performance. Having too many eggs in one basket at the wrong time when you need to access the value of that stock is far from ideal and can be avoided with proper planning.
Understand the concept of leverage and how this can work if your favor. Your ISOs are “in-the-money” when the fair value is in excess of your grant price you would pay - meaning you would come out ahead if exercised. The higher the value is in relation to the price you must pay to acquire the shares, the greater your leverage. Have a plan in place to determine when, how much and at what prices it may make sense to exercise. Blindly hoping the stock will rise forever is not a well-designed plan.
Understand the tax implications. It always makes sense to have a qualified tax professional involved with your planning on ISOs, however it is important that you - the ISO holder - understand the big picture tax impact of doing X, Y or Z with your options. While you can not control the investment performance of your company, you can control your tax impact through proper, prudent planning.
Understand your liquidity needs. For large ISO exercises, raising the cash to acquire stock is only one part of the equation. There are often tax consequences as we have stated. Further, for stock undergoing an IPO or that is thinly-traded, there may be regulatory or systemic restrictions to your ability to sell - thus limiting your ability to raise liquidity from your shares on an immediate basis. Further, we encourage clients to make sure they have ample outside liquidity to properly fund the rest of their financial lives. ISOs are just one piece of the puzzle, it rarely makes sense to ever dive so much into acquiring stock through ISO that is jeopardizes the viability of your overall financial plan.
Ask yourself “why?”. Why do you want to exercise a certain amount of options at a certain price? Are you making it up as you go or is this part of a pre-determined and thought out process? Regardless of your answer we implore our readers to make sure that their ISO strategy fits in line with their overall financial goals. ISOs and other forms of equity compensation are a fantastic advantage in many cases that should be utilized when prudent, however they are often only as profitable and promising as the underlying company involved. Make sure you understand the risk you are taking and how it fits into your bigger picture before jumping into the deep end. It’s ok to say “no” until you have a plan in place.
So after considering all of the competing priorities and variables involved, think to yourself: “Am I taking all of the actionable steps I should to properly position my ISOs for the role I’d like them to play within my entire financial plan?” If you have questions or want to learn more about how we assist people plan with ISOs and take control of their equity compensation programs, feel free to contact us or schedule an introductory call.
Disclosure: (“Hudson Oak”) is a registered investment adviser in the State of New Jersey. For information pertaining to Hudson Oak’s registration status, its fees and services and/or a copy of our Form ADV disclosure statement, please contact Hudson Oak. A full description of the firm’s business operations and service offerings is contained in Part 2A of Form ADV. Please read this Part 2A carefully before you invest. This article contains content that is not suitable for everyone and is limited to the dissemination of general information pertaining to Hudson Oak’s Wealth Advisory & Management, Financial Planning and Investment services. Past performance is no guarantee of future results, and there is no guarantee that the views and opinions expressed in this presentation will come to pass. Figures displayed within this communication are for illustrative purposes only. Nothing contained herein should be interpreted as legal, tax or accounting advice nor should it be construed as personalized Wealth Advisory & Management, Financial Planning, Tax, Investing, or other advice. For legal, tax and accounting-related matters, we recommend that you seek the advice of a qualified attorney or accountant. This article is not a substitute for personalized planning from Hudson Oak. The content is current only as of the date on which this article was written. The statements and opinions expressed are subject to change without notice based on changes in the law and other conditions.