Finding ways to incentivize your employees to be able to retain top talent and continue to grow your business can be difficult for many small businesses. However, with larger corporations headhunting the best talent around, it’s essential to your success to compete using the many tools at your disposal, including one that has been gaining traction recently—incentive stock options or ISOs.
Similar to non-qualified stock options, ISOs are a way to offer equity compensation to your employees for both private and public companies. Offering your employees an ISO gives them a chance to buy shares of company stock at a discount, and they can be an extremely attractive way to keep your retention high for your valued team members. When you combine that with the preferential tax treatment ISOs allow, you’ll wonder why you haven’t started incorporating incentive stock options as part of your perks package before.
So, how do you use ISOs to your advantage and keep the top talent that has taken your business this far? Your friends at Maggi Tax want to make sure that you understand everything you need to know about the basics of ISOs.
And, first, to understand the tax benefits of ISOs, it’s essential that we take a moment to touch on something called the Alternative Minimum Tax, or AMT.
What Is the Alternative Minimum Tax?
Your employees that take advantage of ISOs may quickly find themselves subject to the AMT. But what is it? The AMT is a tax concept designed to ensure that taxpayers receiving certain tax-preferred income, like incentive stock options, pay a minimum tax rate.
Yes, there is an exemption amount for the AMT, which means lower-income employees may not be subject to it. But your higher-earning employees are going to be impacted by it, especially if they’re exercising significant lots of ISOs. The AMT is taxed at either 26% or 28%, making it a lower tax rate than typical NSOs. But what makes AMT unique is that the amount of taxes you pay can be used as a credit on your taxes in future years that no AMT income is reported.
What Do ISOs Cost?
Before you exercise an option, it’s essential to be mindful of the fact that stock options are meant to be optional and not obligate employees to purchase a company’s stock. Of course, when you give employees the opportunity to purchase ISOs, they don’t have to participate if they don’t want to, but more often than not, there is a financial incentive to buy ISOs.
Whenever an employee exercises an option, there are two costs that need to be considered. The first is the cost of exercising the option itself, and the second is the tax ramifications that come with it. The cost to your employee of the option is equal to the “strike price” of the option multiplied by the number of options they’re exercising. As far as the taxes on their exercise, they are calculated based on the “bargain element,” which is the difference between the strike price they paid and what your shares are valued at on the day of exercise. It breaks down more simply as this:
- Cost to Exercise = Cost of Option + Taxes on Exercise
- Cost of Option = Strike Price # of Options Exercised
- Taxes on Exercise = (FMV – Strike Price) # of Options Exercised
What About Qualifying Dispositions?
Qualifying dispositions determine the tax rates that are levied on any exercised options. To “qualify” for this type of preferential tax treatment, your ISO must be offered and available for at least two years from the date it was started and a minimum of one year from the date you first exercised your ISOs.
When any stock is sold after your qualifying disposition ends, you are able to enjoy the benefits of AMT as well as long-term capital gains rates that currently cap out at 23.8%. However, if stock is sold after a disqualifying event, you’re at risk of being taxed at your highest income bracket.
How About an Example?
We have a company that grants 100 shares of incentive stock options to their employee on October 1, 2021. The employee has the choice to exercise their option or buy those 100 shares after December 1, 2023.
That same employee can choose to sell their options at any point after one more year has passed to be eligible to consider their profit as capital gains. That taxable profit is the difference between the strike price and the price at the time of sale.
Some Key Things to Remember
- Incentive stock options are becoming popular ways to compensate employees, especially in small businesses in both private and public companies.
- ISOs grant rights to your company stock at a discounted price at a future date.
- You can use this stock purchase plan to retain key team members and top talent.
- ISOs are required to have a vesting period of a minimum of two years and a holding period of more than one year before they’re able to be sold.
- ISOs typically have more favorable tax treatment on an employee’s profits than other employee stock purchase plans.
If you have any more questions about ISOs and how they can help your business recruit the best candidates for every position or need help working out your capital gains taxes or AMT, give Maggi Tax a call to receive expert care you can count on at 813-850-0131.