What is early exercise of incentive stock options?
Early exercise means investing in the Company earlier, on the expectation that the value of the stock will increase in the future. The optionholder risks losing all or part of the investment if the value of the company's common stock decreases.
Incentive stock options (ISO) are a form of equity compensation that allows you to buy company shares for a specific exercise price. ISOs are a type of stock option–they are not actual shares of stock; you must exercise your options to become a shareholder.
In many cases it can be advantageous to exercise your stock options early (provided you have the cash, and assuming you believe in the company given you accepted a job there).
Exercising a stock option means purchasing the issuer's common stock at the price set by the option (grant price), regardless of the stock's price at the time you exercise the option. See About Stock Options for more information. Choices when exercising options. Example of an Incentive Stock Option Exercise.
Example of incentive stock options
Altogether, you pay $100. The vesting period is four years. Four years later, the stock is selling for $10 a share on the market, meaning you make a $9 profit on each share you purchased if you decide to exercise the option.
You have taxable income or deductible loss when you sell the stock you bought by exercising the option. You generally treat this amount as a capital gain or loss. However, if you don't meet special holding period requirements, you'll have to treat income from the sale as ordinary income.
Often it is more profitable to sell the option than to exercise it if it still has time value. If an option is in the money and close to expiring, it may be a good idea to exercise it. Options that are out-of-the-money don't have any intrinsic value, they only have time value.
There are many requirements on using ISOs. First, the employee must not sell the stock until after two years from the date of receiving the options, and they must hold the stock for at least a year after exercising the option like other capital gains. Secondly, the stock option must last ten years.
If your income for the year already places you in a high income tax bracket, or additional income from stock options could push you into a higher income tax bracket, you may want to delay exercising your options or spread the exercise of options out over a few — potentially lower tax — years.
Cashless Hold
In this strategy, you simultaneously exercise and sell enough stock to cover the cost of exercising the options (and taxes). You receive the remaining shares and any fractional shares will be paid in cash.
What happens if I don't exercise my stock options?
Because if you don't exercise your options before the expiration date, they will be worth absolutely nothing. Nada. Zip. Options are very much a use-it-or-lose-it proposition, and it could be very painful to “lose it” if your strike price is below the current fair market value of the common stock.
Non-qualified stock options are more straightforward, as the tax implications at exercise are generally agreed to be easier to understand. Incentive stock options, while more complicated, offer the opportunity for long-term capital gains if you meet the requisite holding period requirements.
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.
A cashless exercise, also known as a "same-day sale," is a transaction in which an employee exercises their stock options by using a short-term loan provided by a brokerage firm. The proceeds from exercising the stock options are then used to repay the loan.
Employees do not owe federal income taxes when the option is granted or when they exercise the option. Instead, they pay taxes when they sell the stock. However, exercising an ISO produces an adjustment for purposes of the alternative minimum tax unless the stock is sold in the same year that the option is exercised.
Another common question we get when it comes to taxing stock options is – do stock options get taxed twice? Yes – you now know that they do. You'll pay ordinary income tax on the total amount you earn, and capital gains tax on the difference between your strike price and the market price at the time of exercising.
However, there are some reasons why exercising is the right thing to do, so there may be occasions when you do want to. The most common reason for exercising is when you own call options based on an underlying security and you decide you actually want to own that underlying security.
In short, you should exercise your stock options when they have value. But there are other factors to remember, including tax implications and your current financial situation. Whether you're changing careers or your current company is going public, you may have questions about when to exercise stock options.
The ISO $100K limit, also known as the “ISO limit” or “$100K rule,” exists to prevent employees from taking too much advantage of the tax benefits associated with ISOs. It states that employees can't receive more than $100,000 worth of exercisable ISOs in a given calendar year.
Typically, stock options expire if they're not exercised within 10 years from when they're granted. Many companies have an exit within 10 years or go public. However, some companies are staying private for longer, particularly in the current economic climate.
What is the rule of 65 for stock options?
Rule of 65: The Award recipient meets the “Rule of 65” if the Award recipient terminates employment on or after age 50, but before age 55, and the sum of the Award recipient's age and years of service add up to 65 or more as of the employment termination date.
Exercising employee stock options is like purchasing shares in any other company. You now own a small piece of equity in your employer, and it's up to you to decide how and when you will sell those shares, ideally at a profit.
Our advice in a nutshell: If your company offers early exercise AND is less than one year old, you should consider exercising early. Otherwise, wait to exercise until your company begins the process to go public.
You could exercise, buy the stock, receive your dividend, and then either sell the stock or keep hold of it. Another reason for exercising could be if you had specifically bought put options to protect yourself against a fall in price of stocks that you already owned.
The purchaser of an American-style option owns the right to exercise (buy or sell the underlying security at the predefined price) at any time up until the expiration date. The seller of the option is obligated to meet the terms of the contract. However, it does not always make sense to exercise the option.
