ISOs have better tax incentives baked in compared to NSOs. However, to take advantage of these incentives, our equity needs to remain a qualified disposition. Failing to meet certain requirements will result in a disqualification for the incentives and the shares turn into NSOs. If an opportunity is coming to sell our shares, we need to pay close attention so that we don't lose our tax advantage.
- We need to exercise at least one year before we plan to sell
- We need to wait at least two years after the grant date before we can sell
Now that we've committed this to memory, let's step through an example below of how a qualified disposition allows us to only pay long-term capital gains tax.
Exercising and selling at the same time
Let's assume we had forgotten to exercise and there is an opportunity for us to sell our shares. We can still sell and exercise our ISOs at the same time.
Since we haven’t exercised at least a year prior, our ISOs are disqualified. We'll owe regular income tax on the difference between our strike price and the sales price.
Making the most of a tight situation
Alternatively, if we don’t need the cash right away, we can elect to exercise now and sell at another liquidity event one year from now to keep our options qualified. The difference between the sale price and the FMV on exercise would be taxed at the long-term capital gains rate.
This becomes more favorable if the sale price increases during that time, and we can sell for more than $90 per share.
Besides the AMT taxes owed on exercise, ISOs are relatively simple when it comes to taxes owed on the sale of stock. It's normally beneficial to early exercise to avoid AMT altogether. However, if we have not exercised already, we should consider exercising some ISOs at least one year before a liquidity event to make sure they stay a qualified disposition in case we need to sell right away.