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Are there debts, college funds, a home down payment or other compelling factors that require immediate access to the funds? If so, exercising the ISOs and taking the associated profits can make good financial sense. When exercising ISOs, there are two primary possible tax treatments, called qualifying distributions and disqualifying distributions. Qualifying distributions may help minimize your tax liability.
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Qualifying distributions apply when the final sale of the stock occurs at least two years after the option grant date and at least a year after the exercise date. Higher-income earners may also owe the 3. Disqualifying distributions occur when you exercise your options in any other way that does not meet the standard for qualifying disposition.
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One potential benefit of this approach is you have access to the funds from the stocks you sell. This could trigger having to paying the AMT in that tax year. For example, ISOs are reported on Form You may have ordinary income, capital gains or losses , or both, which will be reported on your tax return. Your Form W-2 will include any compensation income received from your employer shown on your W-2, including your income from ISOs upon selling your stock.
It reports capital gain or loss on your tax return. Information on the form will help you determine AMT, if applicable. In the event you are required to pay the Alternative Minimum Tax from profits from selling ISO shares , you will need to file Form Alternative Minimum Tax , which you use to report AMT from the exercise of incentive stock options. If you have a financial advisor or tax accountant, they will be very familiar with these forms and can help you properly prepare your filings.
Incentive stock options are a powerful tool that may help create great wealth. They are also potentially complicated compensation vehicles that integrate advanced tax, investment, and personal financial planning goals. This is why it often takes a specialist in equity compensation or, more likely, a team of individuals to help plan for a suitable outcome. This leads to the fact that there are a number of important decisions to consider when developing your financial strategy around your ISOs. The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.
Diversification does not guarantee a profit or protect against a loss. None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.
Exhibit Sample Stock Option Agreement
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Incentive stock option
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One of the major benefits that many employers offer to their workers is the ability to buy company stock with some sort of tax advantage or built-in discount. There are several types of stock purchase plans that contain these features, such as non-qualified stock option plans. These plans are usually offered to all employees at a company, from top executives down to the custodial staff.
However, there is another type of stock option , known as an incentive stock option , which is usually only offered to key employees and top-tier management. These options are also commonly known as statutory or qualified options, and they can receive preferential tax treatment in many cases. Incentive stock options are similar to non-statutory options in terms of form and structure.
Schedule: ISOs are issued on a beginning date, known as the grant date, and then the employee exercises their right to buy the options on the exercise date. Once the options are exercised, the employee has the freedom to either sell the stock immediately or wait for a period of time before doing so. Unlike non-statutory options, the offering period for incentive stock options is always 10 years, after which time the options expire. Vesting: ISOs usually contain a vesting schedule that must be satisfied before the employee can exercise the options. The standard three-year cliff schedule is used in some cases, where the employee becomes fully vested in all of the options issued to them at that time.
Other employers use the graded vesting schedule that allows employees to become invested in one-fifth of the options granted each year, starting in the second year from the grant. The employee is then fully vested in all of the options in the sixth year from the grant. Exercise Method: Incentive stock options also resemble non-statutory options in that they can be exercised in several different ways. The employee can pay cash up front to exercise them, or they can be exercised in a cashless transaction or by using a stock swap.
Bargain Element: ISOs can usually be exercised at a price below the current market price and, thus, provide an immediate profit for the employee. Clawback Provisions: These are conditions that allow the employer to recall the options, such as if the employee leaves the company for a reason other than death, disability, or retirement, or if the company itself becomes financially unable to meet its obligations with the options.
ISOs can be informally likened to non-qualified retirement plans, which are also typically geared toward those at the top of the corporate structure, as opposed to qualified plans, which must be offered to all employees.
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ISOs are eligible to receive more favorable tax treatment than any other type of employee stock purchase plan. This treatment is what sets these options apart from most other forms of share-based compensation. However, the employee must meet certain obligations in order to receive the tax benefit.