By Peter Mastrantuono
Incentive stock options are a unique way for employees to participate in the long-term value creation of a successful and growing business. They can be a compelling opportunity to generate substantial wealth, but it requires careful planning and attention to maximize that potential.
Stock options are generally granted to senior management and highly valued employees in order to encourage employees to remain with the company. Incentive stock options (ISO) grant employees the option to purchase company stock at a predetermined price (the strike price) for a limited number of years (typically 10 years). ISOs usually have a vesting schedule that requires a holding period before an employee can exercise their option grants.
If a company is doing well, the strike price at the time of the ISO is granted will generally be below the share price at the time an employee is able to purchase the company’s shares (i.e., exercise the ISO). An earlier article, Employee Stock Options 101, is a useful primer that provides additional details on the basic features of stock option incentive plans.
Important ISOs Considerations
For individuals participating in an ISO plan there are a variety of financial planning and investment considerations of which they should be aware, including:
- No taxes are due upon the granting or exercise of an ISO.
- Any realized gains from the exercise of an ISO and subsequent sale of the shares are taxed at the more favorable capital gains tax, provided the shares are held for more than one year from the date of exercise and two years from the grant date.
- If the stock is sold at a loss or fails to meet the holding requirements, the individual will generally pay regular income taxes.
- Exercising ISOs may trigger alternative minimum tax, resulting in a higher tax bill in the year an ISO is exercised—a good reason for why individuals should seek the counsel of a competent tax advisor before exercising their ISOs.
- ISOs may create concentration risk, i.e., too much of an individual’s wealth in a single stock. As a consequence, many individuals choose to sell their company shares to reinvest them in a more diversified portfolio of investments.
Important Questions to Ask
There are a number of questions that individuals need to ask themselves and a financial advisor with specialized knowledge about employer stock options before making big decisions about their ISOs, such as:
- What is the risk/reward of waiting to exercising an ISO and selling the shares?
- What if I don’t have the cash to buy the shares? Does my employer provide a cashless exercise alternative, which is more common, but not automatic?
- How do I best use the proceeds of a sale to address my immediate and long-term planning goals?
- How can a contribution to a donor-advised fund help advance my philanthropic goals and minimize my tax liability?
- My company is about to go public. What does this mean for my stock options? How do I manage cash flow through the post-IPO lock-up period?
To make the most of your ISO compensation, you should speak with your tax advisor and financial advisor to ensure that you have a strategy that best serves your long-term financial objectives and minimizes the amount you share with the government.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.