With the market and economy making progress and with a new round of high-flying technology firms, companies are looking for new, tax-advantaged ways to reward key employees. Back in the glory days of the Tech bubble, the weapon of choice was the “incentive stock option” (ISO), for it’s unique combination of tax benefits and upside potential. The theory was simple: if the company “makes it big,” then the employee will as well, which hopefully aligns the two’s interests together.

About Incentive Stock Options

ISOs are, on the surface, not extremely complex. The company issues the employee an option contract, which grants them the right to purchase shares of company stock at a certain fixed price (e.g. the “grant price”). The employee has a 10-year window in which to exercise that right. If the stock goes up in value, the employee can exercise the right to buy the stock at the grant price, and then he/she will own the stock, and have profited from the increase in value.

For the huge upside, let’s use Apple as an example, because it’s story is so well known. Let’s say you work for Apple, and were granted 1000 ISOs of Apple back in 2001, when the stock was at about $3 (split-adjusted). By 2010, when the stock price was at around $43, you exercise your options and instantly the 1000 shares that you paid $3,000 for is now worth $43,000… So you are “in-the-money” $40,000. Not a bad profit! Of course, if you held those shares until today, your profit is now more than double that.

So that’s a glimpse at the upside potential… that much is easy. For the tax part, the benefit of the ISO versus other stock option plans is that when you sold your shares, you paid long-term capital gains rates on your profits, instead of regular ordinary income rates. For years, long-term capital gains tapped out at 15%, while ordinary income rates could easily double that and more. The trick is, once you exercise, you have to hold the shares for at least one year to qualify for the capital gains rates.

For a much more detailed article on ISOs, click here.

My Oh My, How Things Have Changed

So, the tax strategy to employ with ISOs used to be fairly obvious… assuming you expected the stock to go up, then holding ISOs for at least a year before selling them is the clear way to go. Well, unfortunately, today it’s quite a bit more complicated. There are three main developments over the last decade or so that have contributed to this:

  • Alternative Minimum Tax — AMT is a parallel tax system created back in 1970 to close tax loopholes for the rich. It was designed to set a minimum amount of tax that, no matter how many deductions a person has, still has to be paid. When it was first created, it affected only the very rich. However, the AMT system never included adjustments for inflation like deductions and credits for regular taxes do automatically, so as time passed AMT started hitting more and more “middle class” tax returns. And for ISOs, this becomes particularly important because when the options are exercised (not sold), the amount of gain becomes taxable for AMT purposes. So, if you want to take advantage of the lower long-term capital gain rates, you have to pay the AMT tax in the year you exercise, even though you cannot sell it for a least a year. If careful planning isn’t done, this can put the employee in quite a pinch, because AMT rates can be as high as 28%.
  • The AMT Credit — So if you’re going to be hit by AMT anyway, what is the point of holding the stock for a year? Well because, in theory at least, you get the AMT tax back in the form of a tax credit. However, you can only take the credit in years your regular tax is higher than your AMT tax, and you can only take as much credit as there is difference between the two. Any credit you cannot take can be rolled forward into future years. So, as you can imagine, this makes for some very difficult planning.
  • Higher Capital Gains Rates — You know what I just said about how capital gains rates are capped at 15%? Well, that used to be true. Now, they have been extended to as high as 20% for the highest income tax bracket, which even a middle class worker can be in if he sells a large amount of ISOs.
  • Unearned Income Medicare Tax — Complicating things even further is the recent surtax created by the current administration. This is an additional 3.8% tax for high income earners on unearned income, which includes capital gains. So now, instead of qualifying ISOs being taxed at 15%, you can now find yourself doing everything right and still paying 23.8%.

In Summary

Incentive stock options used to be a really good deal for employees; however, tax planning for them has now become so complicated that few people can proceed without professional advice. We have seen a number of clients with ISOs in recent years, and have extensive experience helping them make sense of their options. With careful planning, ISOs can be a tremendous blessing, but make sure you talk to a Certified Financial Planner™ with ISO experience before making any decisions.