Incentive Stock Options: The Basics & Taxes

Incentive Stock Options, or ISOs, can feel pretty complex... because they are.
What does it mean to exercise?
When should you exercise?
When should you sell?
What in the world is this Alternative Minimum Tax (AMT)?!
Like most things, there is no one size fits all answer. If you're in this situation, I would REALLY stress reaching out to a CFP® professional that specializes in stock comp (🙋🏻‍♂️) and/or a tax professional
The goal of this video is to give a visual break down of how ISOs work and how they are taxed in a couple of scenarios.
www.javawealth.com
#personalfinance #money #stockcompensation

[@TreeLokPNW]

Awesome job. Great supplement to my CFP book.

[@user-tv6tu1hp6t]

This was extremely helpful - thank you!

[@mermaidlifeonearth]

Super helpful. Short and clear

[@yjones2448]

Thank you!

[@ryanmosher8445]

Thank you 😁

[@judyjoohyunlee7643]

Thank you sooooo much

[@crouchingcheese]

Thank you so much for this video. This 7 minutes was so much more helpful than chapters of my textbook!

[@susansusie5480]

Very helpful ! I love the whiteboard, easy to understand!

[@JavaWealth]

Thanks! If you love the whiteboard, you're in the right place.

[@emmieashwell990]

Hi! This was a great video! I am using your content to study for the CFP exam and it has been really helpful! The one part about ISO and tax treatment that I cant seem to wrap my head around is when there is AMT or when to classify as 1040, any feedback?

[@JavaWealth]

Hi Emmie! I appreciate it & it's really cool to hear how this stuff is helping others study for the CFP! - If an ISO is sold in the same calendar year it was exercised, the spread is added to your normal 1040 wage income (line 1) - If it's exercised and held into the next calendar year, the spread is added to the AMT calculation (Form 6251, line 2i) Here's my video that goes deeper into AMT for ISOs: kzbin.info/www/bejne/eoawfHyJnNh9apY Good luck on the exam!

[@sneakyjoe12]

Great video. Thanks

[@KR-uk3df]

I love your videos, so keep up the work! I understand how AMT works, but how does AMT credits work? Is there a video explaining credit part? In my understanding, once you paid AMT taxes (based on paper gain), your strike price becomes $20 in your example. Now, depending on the price goes up/down, you either show loses or pay the taxes on the gain when you actually sell them. Can you help clarify the credit part?

[@JavaWealth]

I touch on the AMT credit towards the end of the AMT Explained video, but admit it doesn't go into all of the nitty-gritty details: kzbin.info/www/bejne/eoawfHyJnNh9apY The cost basis (i.e. the baseline price you use when determining how much gain/loss you have) on your exercised ISOs is different between the "regular" & "AMT" systems. In the regular system, it's still the original strike price. But in the AMT system, you're correct that the cost basis is the stock price when you exercised it. So in practice when you sell your exercised ISOs, your AMT capital gain will be lower. On top of that, there is another negative adjustment made in the AMT calc that further lowers your AMT tax number (Form 6251, line 2(k) for the nerds out there). That combo helps speed up getting your AMT credit back. *** this is not tax advice & I strongly suggest seeking out a tax professional if you have this situation ***

[@joevallone7313]

Nice. Thanks.

[@addiejensen6926]

Hi! Thank you for creating this video. It is great! My question is for the beginning of the video where you talk about exercising the option for the $10 strike price. Does that mean you would have to have the $10K in hand needed to purchase the stocks at that strike price or because the ISOs are gifted to you, is it as simple as exercising them and you immediately get the stock that is currently trading at $20/share. Or is there a way to like use your profit from the options to purchase the shares and that just mean you have less shares that you end up purchasing. I hope this makes sense! Thank you!!

[@JavaWealth]

Yep, good question. You do pay the $10 strike price to exercise the option. If you plan to just exercise & sell it right away, you can usually do a "cashless exercise", in which you don't have to bring any extra money & you'd get the difference. If you want to exercise & hold, you either have to bring $10K in cash, or you can do what you mention at the end of your comment: exercise & immediately sell some of your options to cover the cost of exercising & holding the rest. That's commonly referred to as a "sell to cover".

[@eb1941]

Great video. If I sell my ISOs and pay regular income taxes, is that considered income or capital gains. I ask because I have a capital loss this year on the sale of mutual funds and I am thinking I can use that loss to offset a capital gain from the sale of my ISOs.

[@JavaWealth]

Glad you found it helpful. This segment of the most recent live stream visualizes how ISOs are taxed, depending on when you sell: kzbin.info/www/bejne/lXmXfWSVpNuoqtU So in your scenario, it sounds like you're exercising & immediately selling. In that case, it's all considered ordinary income.

[@weililiu8515]

Thank you so much for this video. I do have a question. I did some research and found that there is a yearly limit of $100K on company issued ISO. Assuming the company granted $200K (at strike price) in a certain year, does that mean only 100K will be considered as ISO and will have the tax benefits discussed in your video? All others will be treated as NSO and will be counted as regular income when exercised? What if I exercise only 100K in a year and wait for another year to exercise the other half?

[@JavaWealth]

Yes, only the first $100K worth of options can be considered ISOs, the rest will be granted as NSOs. That stays the case regardless of how many you exercise in a given year. Glad you found the video helpful!

[@innovativefacultytrainingkota]

Good

[@sportsmoaaz1292]

Is it better to exercise and hold when the price of the stock is lower? For example if my option price is $10 and the stock price was $100, but now is $20 is this a good time to exercise my options? Does the smaller delta in the current stock price and my option price help with taxes?

[@JavaWealth]

If you plan to hold onto the stock into the next calendar year, exercising when the price is lower does help in regards to how much (if any) alternative minimum tax (AMT) you'd pay b/c your bargain element (spread) is smaller. I get into more detail around AMT in this video: kzbin.info/www/bejne/eoawfHyJnNh9apY That being said, there are more factors to consider than just taxes when deciding if/when to exercise ISOs.

[@iiN1GH7M4R3ii]

this was a pretty good explanation!! I have 1 Q: Is exercising when the options are turned into actual shares?

[@JavaWealth]

Yes, exercising means acquiring the underlying stock by paying the exercise price. (2:10) I appreciate the kind words!

[@iiN1GH7M4R3ii]

@@JavaWealth 11 years later and you're still helping people out.. thank youu!!!!

[@jamesdowns1246]

Do you get the AMT tax credits in the next year regardless of whether or not you decide to sell the ISO shares in that following year? That was not clear to me...otherwise this is an excellent video.

[@JavaWealth]

You can only claim AMT credit to the level that your "regular" tax calc is higher than your AMT tax calc. Most "normal" years when you're not exercising ISOs will provide room to claim at least some of the credit. Also, selling ISO shares generally does increase that difference between the two, but it's not a straightforward "sell everything & get your AMT credit". I go into the AMT credit in more detail in this video: kzbin.info/www/bejne/eoawfHyJnNh9apY Hope that helps, James!

[@jamesdowns1246]

@@JavaWealth Thank you!!!

[@georgec9765]

Can I ask you a quick question? For example if my option price is $100 and the stock price was $120, but now is $50 is this a good time to exercise my options? It is like I can just sell it based on $50 and I don't need to buy them with $100 (nobody would buy that option obv)

[@JavaWealth]

Assuming we're talking about a public company, there's no benefit to exercising an option that is underwater (option price > current stock price) because you can buy it directly on the open market for less $. Does that answer your question?

[@nicholasshook7513]

Do you have to put up the money to exercise? Or does the company cover the cost?

[@JavaWealth]

Generally, yes. Another common practice is to do a cashless exercise, which is exercising and immediately selling enough of your options to cover the cost of holding others. There are some cases where your company or a third party will loan money to cover the cost of exercising.

[@brandonrichards7871]

Is there a AMT for ISO if you did a sell to cover option to excersise those ISOs to get them into my possession rather than pay cash out of pocket?

[@JavaWealth]

Great question. Short answer is "yes", there is still potential to trigger AMT, but it would be lower. The ISOs that were exercised and immediately sold to cover the full exercise cost will be considered ordinary income. The spread (or bargain element) on the remaining shares that you hold onto is still subject to AMT.

[@brandonrichards7871]

@@JavaWealth so essentially once excercised i get taxed AMT because it's money i never had but now I do. But because I'm holding the stock for LTCG I could "earn" that amt amount back in later tax years after I sell? Am I understanding this correctly? I hate taxes. Its so confusing.

[@JavaWealth]

You’re on the right track. Maybe this could be another video, and my apologies if the following explanation makes it worse: AMT is a completely different formula for figuring out taxes. For most people, it ends up being a lower number that your regular tax calculation. But the AMT system counts the spread of any ISOs that are exercised AND held past the end of the year (the $10K I point to in the video), and it can make your AMT calc the higher one. Example Regular system: $30K AMT system: $35K In this case, you’d pay $35K in taxes. The $5K difference is the AMT credit that carries forward. In future "normal" years where your regular tax is higher, the AMT credit can be used to lower your taxes (although there are more complexities around how that works too… of course).

[@brandonrichards7871]

@@JavaWealth me again lol So I've been trying to educate myself on the whole AMT with ISOs. I'm going to say what I understand from you as well with what I've read online. And yes perhaps a video in greater detail may be needed. From what I understand, I'm paying an upfront tax. Essentially since I didn't sell all my options and held on for the long term, they consider what the cost to excersise as income correct? The tax is on the amount difference between the strike point and the FMV at the time of sell correct? But this AMT will more than likely become a credit in the year or years I sell my long term options. And the credit is calculated as this?: My excersise puts me into the 24% tax bracket for income for the year. But when I sell long term in a few years, it's now subject to LTCG tax at 15%. Because I already paid a large tax on these shares I'd essentially be getting a credit of the percentage difference. 24%-15%=9% credit on that year I sell those options. An I understanding this correctly? If so, in order to cover said AMT I'd have to sell more shares as my AMT would be pretty hefty. By doing that I'd be taxed STCG at an income rate for this year 2021. I highly doubt you can tell the IRS "hey I sold stock to pay taxes so please don't tax this sale". If I'm so far kinda correct, how would I claim an AMT credit I future years? My employer is teamed up with TurboTax. Perhaps I should get a professional. Like I said. I hate taxes and it's confusing. I appreciate the quick responses and detailed info. I'm learning alot and I hope.my situation can help clear up issues other may face if they choose ISO.

[@JavaWealth]

Hi Brandon, I just posted a new video that explains AMT in greater detail: kzbin.info/www/bejne/eoawfHyJnNh9apY Hope it helps!

[@AB-wq2bg]

What's the process for "buying" those shares at exercise though? You're not actually fronting cash, right? It's just a contract that says you have rights to these amounts, no? Can you explain the cash flow process?

[@JavaWealth]

You actually are buying them. "Exercise" is just a fancy way of saying "I'm going to pay this set price to buy this stock". If you plan to just exercise & sell it right away, you can usually do a "cashless exercise", in which you don't have to bring any extra money & you'd get the difference. If you want to exercise & hold, you either have to front the cash, or you can exercise & immediately sell some of your options & use that profit to cover the cost of exercising & holding the rest. That's commonly referred to as a "sell to cover". Hope that helps!

[@malinzju]

What's the tax implications of donating exercised ISO shares to charity?

[@JavaWealth]

That's a really complicated question that depends on a few things (are they long-term/qualifying, AMT credit impacts, etc.). Here is a great article on the topic by Daniel Zajac, who also specializes in equity comp planning: zajacgrp.com/insights/donor-advised-fund-contribute-incentive-stock-options-non-qualified-stock-options

[@laurah2023]

Your video helped me so much with my CFP studies. The visualization of Grant, exercise, and sell was a huge help. An ISO question was on my exam and you helped me get it right!

[@JavaWealth]

Wow, I'm really humbled to hear that. I'm a big proponent for the CFP marks and that exam is no joke. Congratulations!

[@FreedomAtRisk]

Does 83b election have anything to do with the two time periods you describe here?

[@JavaWealth]

Yes. Doing an early exercise + filing your 83(b) starts the clock on the "hold for > 1 year after exercise" time period for it to qualify for long-term cap gains. I'll cover the pros and cons of 83(b) elections in more detail in an upcoming video.

[@FreedomAtRisk]

@@JavaWealth thanks! for better or worse I filed the election...!

[@webchamp930]

Wow thanks for simplifying this! I had an hour long meeting at work about this topic, and it was very over convoluted. My question is do the long term capital gains get taxed based on where one is located when purchasing the options or when selling the stocks?

[@JavaWealth]

Unfortunately, there isn't a straightforward answer. Each state has its own rules on how they're taxed based on residency, type of sale, etc. For example, CA has their guidelines published here: www.ftb.ca.gov/forms/misc/1004.html. I'm glad to hear that this video helped out. I appreciate the feedback!

[@webchamp930]

@@JavaWealth thanks for the info 🙏

[@colinbell3374]

Does anyone have an example of a time when you should not exercise your options immediately once they become available?

[@colinbell3374]

Assuming of course, that the options are over the exercise price.

[@JavaWealth]

Hi, thanks for the question. There is definitely risk in exercising & holding your options. You're putting up money to exercise + possibly having to pay AMT at tax time. And if the stock then goes down, it can more than wipe out any tax savings you'd get from holding past the point of it being a qualifying sale. This happened to a lot of people after many tech stocks tanked in late 2021-early 2022. I had an in-depth discussion about this topic in a live stream: kzbin.info_H4L1_ovuts

[@akhilkumarraparthi8179]

thanks for the very informative video. it's really helped me a lot to understand this as simple and eassy.

[@pixelroutine4609]

You can only sell if your company has decided to IPO. You could sit on these ISOs forever.

[@JavaWealth]

Yes, there are a lot of different scenarios & considerations re: holding ISOs in a private company. More broadly, it's waiting for some kind of liquidity event (IPO, acquisition, tender offer, etc.). In some cases, you may be able to sell on secondary markets. I had an extensive conversation w/ another equity comp specialist on this: kzbin.info/www/bejne/aJO7dIGaftlrkMk

[@erikandersen6125]

I have to pay taxes on the stock when it vests, do I still have to pay taxes on the same stock when I've sold it?

[@JavaWealth]

When ISOs vest, it just means you have the ability to exercise them and turn them into stock. But the act of vesting doesn't trigger taxes. This possibly sounds more like RSUs? I did a similar video on those as well, and explain how those work and are taxed. kzbin.info/www/bejne/bKubqqSpgKyksJI Hope that helps! Thanks, -Mike.

[@srikanthreddy4689]

Plz tell taxation in the case of cash out scheme under option cancellation agreement?

[@Mel-by7re]

is the strike price usually the same before IPO and after IPO since it was granted to you at a specific price or does it change?

[@VictorGyo]

Strike price stays the same in accordance to the contract you were granted those options. If you were to get another contract for more options later on, those newer options might be at a different strike price.

[@Mel-by7re]

@@VictorGyo so if one needs to exercise before IPO and after IPO strike price is what you pay then? thanks

[@JavaWealth]

Yeah, Singularity is right. The strike price that is in your grant document doesn't change. So the exercise cost is the same regardless of whether it's pre-IPO or post-IPO.

[@VenkatAkkinepally]

This is by far the clearest explanation I've seen. Thank you!

Hello!. If when I exercise my right, I pay $ 10 and not $ 20, the remaining 10 are paid by the company? I am buying a share at $ 10 when it is worth $ 20, ok? But if the company has to pay the rest, I am not forcing a company expense and consequently the company is worth less. Or is it that the company has already paid for those shares when it has offered me the shares at $ 10? Thanks!

[@jamieK111]

The company creates the shares of ownership in the company and offers to sell you a share for $10 as an incentive. If the market value is $20 they are not paying out the other $10. They are losing the opportunity to sell that one share for $20. That should not be a problem unless the company's whole business model is selling shares in itself :)

[@jamieK111]

It's a bit like if you and a friend want a lemonade stand that costs $20. You're going to own 1/10 but only chip in $1 instead of $2. In return you have to build it. If the lemonade business is worth $100 later, your $1 turns into $10 and your friend's $19 turns into $90. They could have made more by not offering you ownership or by not giving you a discount, but that was the deal.

[@Mel-by7re]

is the 20$ called Fair market value in your example? when the company is already public and you want to exercise your vested shares, does the company give you the strike price and does FMV is actual trading price of the stock on that particular day and particular time? thanks

[@JavaWealth]

Yes, in my example, $20 was the FMV at time of exercise. To clarify, the company doesn't "give you the strike price". You pay the strike price to exercise your option to turn it into a share of stock. From there, you can turn around and sell the stock, or hold onto the stock to try & qualify for the preferential tax treatment.

[@SF10013]

Thank you! You explained it so clearly

[@alexclaesson8329]

Do you have to pay AMT when you exercise? Or is there some kind of grace period?

[@JavaWealth]

AMT is calculated when you file your taxes. So if you do end up owing more due to exercising ISOs, you'd pay it then. FYI, I'm working on a video that will try to explain how ISOs and AMT play together in more detail.

[@dawnmckinney3665]

Thank you for sharing your expertise! I was just awarded some vested stock and was at a loss! I definitely want to hold and wait so I can take advantage and get the lower tax.

[@mariaespejo2190]

Just one simple question: if I just exercise and not sell, do I need to report that to the IRS on my taxes?

[@JavaWealth]

Yes, you would need to determine if the spread between your strike price & the FMV at exercise (aka bargain element) triggers AMT. I go into further detail around AMT in this video: kzbin.info/www/bejne/eoawfHyJnNh9apY

[@Dr.FeelsGood]

Hi there, quick question for general hypothetical situation that has no basis in reality and will just be fun to talk about and not be taken as advice: Say I was granted 50k shares at 15 cents a share in early 2018 during the seed investment phase, then had several rounds of funding via series A, B, and very recent C and was granted some more shares at higher strike prices over the two years. I am currently vested in about 50% of the shares and would be vesting in another chunk in early 2021. If the company just had a series C and now the strike price jumped from 65 cents to at least $3 for options for a $70million valuation, and the company plans on going public or IPOing soon...when is the best time to exercise? Is it worth the risk of losses at this point to exercise right now given that the series C shot the price up so much and incur potential high AMT? Would it be smarter to wait until early 2021 when I get the next big chunk vested to exercise and try to hedge that the company won't sell or IPO in a year? Can I hold onto the stock after the IPO or sale and still reach that year period? I assume I am going to be taxed on the rest of the unexercised, unvested stock and have it put on my W2 like what happened last time I was in a startup (private and shady) that got bought out and had no option to exercise any shares early, despite having a vesting schedule. I was taxed almost half my earnings in that event due to the company cashing out our ISOs for us by taking out loans on our behalf, putting my w2 wages at 700k higher than normal and I lost half the earnings.

[@JavaWealth]

The decision on when to exercise in a private company hinges on a number of things. First is whether you have the money to pay for it since you can't sell shares to cover the exercise cost. Here are a few options w/ some of the pros and cons: 1.) early while valuation is low - higher risk that you just threw money away, but higher potential and lower tax hit 2.) shortly before IPO - better probability that it's worth something (still not guaranteed), starts the 1 year clock 3.) after IPO - known value, can sell shares to cover the exercise cost, can decide whether to take the money now or wait the year to get LTCG rates Wealthfront also has a good article that talks through it: blog.wealthfront.com/equity-ipo-guide/exercising-stock-options/ Acquisition can happen a few different ways, as you "hypothetically" experienced ;).

[@keatomatic8535]

Have watch a ton of videos on this, and yours is the clearest and most concise. Thanks

[@ellemason2055]

How is this different from ESOP?

[@JavaWealth]

In the US, an ESOP stands for Employee Stock Ownership Plan. Think of it as having a 401(k)-like retirement account where your employer is contributing company stock. So it's unrelated to stock options. In some other countries, such as India, an ESOP is an Employee Stock OPTION Plan. In that case, it's the same thing as this video.

[@Gervin37]

when you exercise, are you essentially using your own funds? So in this case, you would need to have saved $10,000 to exercise?

[@JavaWealth]

Yes, in this example you'd have to bring $10K to the table to exercise & hold all of the shares. If it's a public company, another common method is to do a "cashless exercise" where you'll exercise & immediately sell some of your ISOs to pay the exercise cost of the rest of them. This video is a bad example for that since the total value of the ISOs isn't more than the exercise cost.

[@jared8572]

Thanks for the video, I feel like I’m starting to understand a bit. So if I exercise and sell immediately, I will only be taxed at my current tax rate? I live in Oregon, do I pay both federal and state taxes on the money I made? I’m in the 22% tax bracket. Does this mean I only have to pay a 22% tax on the money I made from selling the ISO’s and that’s it? Do I pay this when I do my taxes? Sorry for all the questions

[@JavaWealth]

If you exercise & sell immediately, then the bargain element amount (your gain) will get added to your wage income. Generally speaking, no taxes are withheld automatically when you ex&sell ISOs, so it becomes your responsibility to know how much to either a.) pay through estimated tax payments, or b.) put aside to pay when you file your taxes. This would apply for both federal and your state taxes. The good news is there is no SS or Medicare tax on ISO income.

[@MattFerguson26]

What happens if price goes down when vesting, get $0?

[@raymondwong336]

You didn't explain how to calculate the gain for AMT which is the FMV minus the strike price.

[@JavaWealth]

Hey Raymond, good point. I went into further detail around AMT & ISOs in it's own video: kzbin.info/www/bejne/eoawfHyJnNh9apY

[@plumbersunited8177]

Save yourself the trouble and exercise while the price is still low. If you exercise AND sell, you not only pay taxes for what you sell, you pay taxes for what you exercise too because that's considered INCOME! Talk about double taxation and theft!