The Startup Employee’s Regular Tax Liabilities for Exercising ISOs
The government’s favorite season is here again: tax season!
In addition to income and property taxes, startup employees need to also consider the tax implications of exercising incentive stock options (ISOs). We know that taxes are your least favorite subject, mostly due to long-winded rules that change often. This post will help make your life a little easier by breaking down your tax liabilities for exercising ISOs.
What Actually Is the “Incentive” for ISOs?
You may have heard that ISOs have more favorable tax incentives than other stock compensation programs like non-qualified stock options (NSOs) or restricted stock units (RSUs). This is true!
There are two types of stock options we will discuss in this series: Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NSOs). ISOs may be more tax-favorable than NSOs. Unlike NSOs, which are subject to ordinary income tax rates, ISOs may or may not be subject to the Alternative Minimum Tax (AMT). Depending on the state that you reside in, you may or may not be subject to AMT on both the federal and state level when you exercise your options.
Despite this, exercising ISOs still typically results in a more favorable tax treatment than exercising NSOs. In general, ordinary income tax rates are relatively higher than AMT rates. Depending on the level of your household’s adjusted gross income, you may not even be subject to AMT if your income does not meet certain thresholds. This is a huge benefit for employees who have the ability to exercise ISOs.
The eventual cost of these taxes will depend on how long you have held the stock. In 2021, the sale of ISOs could be taxed between 0% and 23.8%  capital gains tax rates that are significantly lower than federal ordinary income tax rates. So it makes sense that it’s quite common for startup employees to receive ISOs as a part of their compensation packages. Employers see these tax benefits as an opportunity to attract and motivate employees.
This Sounds a Little Too Good to Be True…
There are, of course, other requirements that you have to meet in order to take advantage of these tax benefits. For one, you need to meet these holding requirements:
- You must have held your ISOs for at least one year after exercising, and
- You must have kept your ISOs for at least two years after the options were granted
If you meet these requirements, exercise your ISOs, and ultimately profit off the sale of your stocks, these profits will be treated as long-term capital gains. This means that they will be taxed at a significantly lower rate than the ordinary income tax rate. Keep in mind that, at the time of exercise, you may be subject to AMT if you hold shares past the year-end of exercise. This will be explained in more detail in future posts.
If, for any reason, you don’t meet these two holding requirements with your ISOs, you will be taxed as if you’re holding NSOs.
Why Are Some ISOs Converted to NSOs?
There are some benefits to converting your ISOs to NSOs, but this does nullify the tax incentives for ISOs. Advantages of this conversion include:
- You don’t have to put your career’s progression on hold to remain at the same company, especially because an IPO is never guaranteed. 
- If your stock option plan allows it, keeping your unexercised options as NSOs enables you to “wait and see” how the company is doing before you exercise, and potentially empowers you to capitalize on future profits.
With all of that being said, there may be additional clauses that impact you during this conversion process, such as the exercise window being shortened. Still, it is likely that this window will ultimately be longer than the 90-day PTE window that is allowed for ISOs.
Got It. What’s Next?
If your tax bill is too large for you to handle, there are other options. Depending on what you can afford, you can exercise a portion of your stock options in order to keep the costs reasonable. You can also work with Equitybee to find the funding that you need in order to exercise your options and take care of your taxes.
Throughout this entire process, we strongly encourage you to discuss these complex matters with a tax professional. Regardless of which path you choose for your ISOs, your tax professional will use IRS Form 3921  to calculate the AMT impact of the exercise.
Now that you have a more comprehensive understanding of the tax liabilities for exercising your ISOs, we recommend that you check out our ISO decision tree. This digital tool will walk you through the multiple decisions that you need to make in order to set yourself up for financial success.