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ISO exercise and sales tax

Lesson in Course: Finance at work (advanced, 6min)

We're thinking about exercising and selling our ISOs. What should we expect around taxes?

Eureka!

What it's about: The tax rules for selling ISOs.

Why it's important: Keeping our ISOs as qualified dispositions requires planning and can save us a lot of taxes.

Key takeaway: Exercise a year before we plan to sell our shares and make sure it's been at least 2 years since we've received our ISO grant.

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. 

Qualification requirements

  1. We need to exercise at least one year before we plan to sell
  2. 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.

Qualified ISO taxes

We were granted ISOs at a strike price of $30 per share. We forgo early exercise and decide to wait to exercise our options a year later. The FMV at the time was $50. We ended up selling our shares for $90 each a year later.

Source: PwC

In the example above, the graph on the left shows the outcome when we've fulfilled the selling requirements and our ISO is considered a qualified disposition. This means that we've waited a year after exercising to sell and at least 2 years after the grant date. The qualified disposition results in the $60 difference ($90 - $30) between the sale price and the strike price being treated as a long-term capital gain

At a long-term capital gains tax rate of 15%, we would be looking at $9 worth of taxes per share sold. Note, the $20 difference between the FMV of $50 on exercise and our strike price of $30 may trigger AMT. 

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.

We can combine exercising and selling together

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.

Disqualified ISO sale

In the graph above, we can see that we'd owe taxes on $60 worth of income for every share sold. This should look familiar as it is the same outcome if we exercise and sold our NSOs at the same time.

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. 

Waiting another year

This becomes more favorable if the sale price increases during that time, and we can sell for more than $90 per share.

Actionable ideas

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.