So you’ve got Incentive Stock Options. Perhaps you just signed an offer letter with an equity package, or maybe you’ve been sitting on a vesting schedule for a few years, vaguely aware that you should “do something” with your options but not sure what. Either way, you’re in the right place.
ISOs are one of the most valuable yet complicated parts of compensation. They can be incredibly lucrative. But they come with a set of decisions that, if you get wrong, can cost you real money. Sometimes a lot of it.
Here’s what I think you should know.
First, the Basics
An ISO gives you the right to buy shares of your company’s stock at a set price, your strike price, regardless of the current price of the stock. For example, let’s say your strike price is $2 and the stock is worth $20, you get to buy at $2.
But having options isn’t the same as owning stock. You don’t get anything until you exercise, meaning you actually pay that strike price to buy the shares. And that’s where the decisions begin.
The Core Tension: Taxes vs Risk
If there’s one thing I want you to take away from this post, it’s that nearly every ISO decision comes down to a tradeoff with time at the center of it.
Exercise early and you minimize your tax exposure, but you’re now putting real money at risk.
Wait longer and you reduce your risk of loss. But while you’re waiting, the gap between your strike price and the stock’s fair market value may be growing. And that growing gap is exactly what creates a larger tax bill when you finally do exercise.
This tension between risk and taxes doesn’t have a clean answer. But understanding the tradeoffs can help you avoid an expensive mistake
Exercising Is Not Free
This sounds obvious, but it’s important from a planning perspective. Exercising means coming up with the funds to purchase the stock. If you have 10,000 options at a $3 strike price, exercising all of them costs you $30,000 out of pocket. That’s money coming out of your pocket regardless of what the stock does after you exercise. Remember, it doesn’t always go up.
So the question becomes: how much am I willing to risk, and how am I going to pay for it?
The Tax Advantage Is Real, But It Has a Trap Door
ISOs have the potential for preferential tax treatment. When you exercise an ISO, you don’t owe regular income tax on the spread, the difference between your strike price and the current fair market value. With NSOs, you’d owe ordinary income tax on that spread immediately, even if you kept the stock. With ISOs, unless you trigger AMT, you don’t owe taxes until you sell. If you meet the timing requirements, you can sell the stock and pay capital gains tax on the proceeds instead of ordinary income. This can be a sizeable tax savings.
But here’s the trap: the spread when you exercise counts as income for the Alternative Minimum Tax (AMT).
AMT is a parallel tax calculation that was originally designed to make sure wealthy people couldn’t use deductions to pay zero taxes. But in practice, it catches a lot of people exercising ISOs.
Here’s an example. Say your strike price is $1 and the current fair market value (called the 409A valuation for private companies) is $10. You exercise 20,000 shares. You just created $180,000 in AMT income. You calculate your taxes using two different methods, the regular way and the AMT way, and pay the higher of the two.
That’s the trap door. And people walk through it every year without realizing it’s there.
There is a silver lining though. If you pay AMT in one year, you may be able to claim an AMT credit in future years. Let’s say that your regular tax bill calculated to be $100,000 but your AMT calculation led to owing $130,000. The $30,000 difference could be an AMT credit in a future tax year. It doesn’t eliminate the sting of a surprise AMT bill, but it can help. It’s worth factoring into your planning.
Exercise Early to Minimize Taxes
If you exercise when the spread between your strike price and the fair market value is small, the AMT hit is minimal or doesn’t apply at all, and you start the clock on long-term capital gains treatment (more on that in a second).
But it’s not a free lunch, you’re trading tax efficiency for uncertainty. If the stock drops after you exercise, you’ve paid taxes on money you never made. The key is being honest about how much risk you’re comfortable taking on.
Calendar Considerations
Here is another common timing tradeoff. Let’s say next year, you are planning to exercise options and anticipate needing a decent amount of funds to cover the cost. You might want or need to sell shares to cover the costs. The sooner you exercise shares this year; the sooner you meet the time requirement to sell shares and receive the preferred long-term capital gains treatment next year.
This may be ideal on paper, but if your income varies, you may need to wait to exercise until later in the year to have more clarity on your total income before deciding how many shares you exercise.
If you find yourself stuck in this tug of war, you could consider exercising some early in the year to start the clock for capital gains purposes, while giving yourself a buffer to account for choppy income throughout the year and exercise the rest near year end.
The Holding Period
To get the full ISO tax benefit, paying long-term capital gains rates instead of ordinary income rates on your profit, you need to meet two holding requirements:
- Hold the shares for at least 1 year after you exercise.
- Hold the shares for at least 2 years after the option was granted.
If you sell before meeting both of those, it’s called a disqualifying disposition, and your profit gets taxed as ordinary income, just like an NSO. That can be a difference of 15-20% in tax rates depending on your bracket.
Sometimes the “Wrong” Tax Move Is the Right Financial Move
In some cases, it may make sense to exercise and sell immediately, even though it triggers a disqualifying disposition. This creates a higher tax bill because you pay ordinary income rates instead of capital gains. Why would anyone choose that? Because by selling right away, you lock in a known outcome. You’re no longer exposed if the stock drops sharply. Or it might be the only way you can generate the funds needed to cover the costs to exercise.
The point is this: the “optimal tax move” and the “optimal financial move” aren’t always the same thing. It can be perfectly rational to exercise some shares early, while waiting on others. Getting the most out of your stock compensation hinges on understanding these key elements and making decisions with taxes and risk in mind
As a reminder, stock options have a timeline. If you leave the company or there is a corporate event, that timeline can be greatly accelerated.
The Bottom Line
ISOs can be a great benefit, they offer tax advantages you won’t find in most other forms of compensation. But they come with important decisions.
Almost all of those decisions come back to the same core tension: acting sooner is better for taxes but riskier financially, while waiting is safer but potentially more expensive. There’s no universal right answer. But the people who do well with ISOs are the ones who understand this tradeoff, think carefully about where they sit on the spectrum, and make deliberate choices instead of default ones.
Contact us today if you would like help talking through your situation
