The three main things to know about ISOs

In order to understand ISOs, there are three main things. First, they are granted to you, then you exercise them, and then you sell them. 

So the first important thing is whenever you're given ISOs, they are granted to you and there's a certain date that you're granted them. There are two pieces of information that are really important. 

1. First is the number of ISOs that you are granted and so in our example, we're going to say that you are granted 1,000 ISOs. 
2. Now the next important piece is what the exercise price is. it's also called the strike price or the grant price. We're going to say that the exercise price is ten dollars per share 

Once that happens, then really the next thing for you to do is just stick around at your job because most of the time they are going to have something called a vesting schedule that is tied to these isos so it's saying that you can't actually exercise or sell this stuff until you've stuck around for a period of time. That's called the vesting schedule and so once they have vested then that's whenever you're able to actually act on these isos.

The decision to exercise

Let's assume that we have passed the vesting period and now we have decisions to make. So the next part is the decision to exercise these options. What exercising means is that we are going to pay this price to turn this option into an actual share of stock. 

So in our example, in order to exercise all of these shares, you would be putting up $10,000 in order to own 1,000 shares of this company's stock. In this case, we're saying that whenever we get to this point that the stock is actually worth $20,000 per share - It's a good deal because you could pay $10,000 to buy something that is actually worth $20,000.

Selling and taxes

The first option after you exercise is to immediately sell it. The nice thing about that is that you lock in the amount of money that you've made. So from a tax perspective, this $10,000 that you gained gets taxed as income, so it gets taxed at your tax rate.

On the other hand, another option that you can do with ISOs that helps from a tax perspective is that you exercise it here, but then you actually wait, and you don't sell it yet. 

Instead, if you exercise and then wait a period of time before you sell at that later period of time, then there's a possibility that instead of this getting taxed at your in that as ordinary income (at your ordinary income tax rate) then it can get taxed as long-term capital gains.

That could be a difference between being taxed at 32% and instead taxed at 15%, so you can see how there could be a pretty large tax benefit for you waiting, which sounds pretty nice.

How to get the tax benefits of ISOs

So how do you how long do you have to wait in order to get that preferential tax treatment?

Well, it's all based on these three dates (grant, exercise, and sell dates). 

1. The first thing that you have to do is you have to wait at least a year from the time that you exercise before you sell it.
2. Then the other thing that you have to do is you have to wait more than two years from the date that you sell it and the date that it was actually granted to you.

So in this scenario, let's say we've done this. Let's also say we've lucked out, and, in that period of time, it's actually gone up from $20 to $25 per share. So what happens is that the entire amount from the $10 exercise price to the $25 fair market value of that stock, all of that gain, gets taxed as long-term capital gains.

Seeing this, you can see the tax benefit of doing this - where you exercise, and then you wait more than a year before you actually sell it. As long as you satisfy these two time periods, then basically what we're saying is that instead of having this being taxed at for example 32% you're getting taxed at 15%. So you can see that there could be a pretty big advantage of waiting that period.

The drawbacks of AMT

So this all sounds good, right? Well, there is one catch and that one catch, and it's called AMT. 

Where AMT comes into play is in the scenario where you exercise, and you have a gain. If you don't sell it within that same calendar year, then this gain is considered a preference item for AMT. So there's a possibility that you actually have to owe a little, and you have to pay taxes on this based on the alternative minimum tax formula.

So, the bad part about that is you're actually paying an extra tax on something where you actually haven't sold it, and you haven't realized any of the money for it. You would have to pay that out of pocket, but the nice thing about it is that you would pay that in this tax year. Then in future tax years, you're generally able to recoup that through AMT credits.