Incentive Stock Options: What You Need to Know for the CFP® Exam
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One of the many areas that might give you some problems on the Certified Financial Planner™ exam involves ISOs and NQSOs. The reasoning is for many, it’s an area in practice that you may not have much experience with. Additionally, some of the rules of ISOs and NQSOs seem to overlap which naturally can trip you up on the exam. Also, when you’re dealing with tax implications of NQSOs and ISOs, things could get complicated. However, if you simply commit to memorizing a few basic facts, you should be able to ace the questions the CFP® exam throws at you. Also, you’ll want to remember the main difference between ISOs and NQSOs is that ISOs postpone taxation until the stock is actually sold, whereas with NQSOs, income taxes are assessed immediately upon exercise.
In this article, we will review the most important things you need to know about ISOs and in a follow up article, we’ll tackle NQSOs.
For Starters, what are stock options?
Stock options are rights given by a corporation to an employee that allow the employee to buy their employer’s stock at a certain point in the future at a specific price. Stock options are used to attract, reward and retain employees, particularly key employees. Keep in mind that stock options simply give the employee the right to buy company stock; they are not obligated to a purchase agreement. Therefore, if the stock price falls, the employee simply allows the option to expire. No harm, no loss.
As for ISOs, the Certified Financial Planner™ exam wants you to know that they can only be issued under a written plan approved by the stockholders of the corporation. ISOs are “tax-qualified” meaning if you follow a few basic rules, then you’ll be given favorable tax treatment i.e. capital gains taxation instead of W2 income on part of the transaction. Other things to keep in mind are the exercise price (the price at which you get to buy the stock) has to be at a price that is at least as much as the fair market value at the time of the grant. ISOs have a shelf life of 10 years, and have to be exercised within 3 months of retirement or severance from the company. Additionally, no more than $100,000 of ISOs can be exercised in any particular year. Keep in mind that when the ISO is granted to the employee, there is no taxation.
To get favorable tax treatment (capital gains) on a portion of the stock’s gain, it’s vital to remember that the option holder has to satisfy a couple of holding periods. In order to enjoy favorable tax treatment on part of the stock sale, the option holder must wait for more than 1 year after the option’s exercise AND 2 years after the grant to sell the stock and qualify for capital gains. A simple way of remembering the timing is to think of the letters E and G and where they fall in the alphabet. Since the letter E comes before G, I just assign year 1 to E and year 2 to G.
I mentioned earlier that upon exercise of the option, no income taxes are due and as long as the 1 and 2 year holding periods are satisfied, ordinary income taxes will be due only on the bargain element. The bargain element is derived by subtracting the exercise price from the FMV of the stock at the time of exercise. Therefore, everything above and beyond the FMV on the date of exercise will be taxed at LTCG rates. However, keep in mind that the taxpayer may be subject to the Alternative Minimum Tax on the spread or difference between the purchase or exercise price of the option and the fair market value at the time of exercise.
As a recap, here are the things you absolutely have to know regarding ISOs:
1. There is no income tax when the ISO is both granted by the employer and when exercised by the employee
2. The difference between the exercise price and FMV on date of exercise subjects the employee to AMT
3. If the 1 and 2 year holding periods are met, then all gain above the FMV on date of exercise will be subject to capital gains. Either short-term or long-term capital gains tax rates will be applied depending upon how long after exercise the stock is held. If the stock is sold more than 365 days after exercise, then LTCG rates will apply. A holding period of 365 days or less means the taxpayer has to pay STCG rates.
4. ISOs have a 10-year shelf life
5. The exercise price must be equal to at least the FMV of the stock at the time of grant
6. No more than $100,000 of ISOs can be exercised in any one particular year.
As for ISO questions on the CFP® exam, it’s very likely that the higher value questions will revolve around the tax impact of ISOs. Make sure you know the rules but also be certain that you get plenty of practice doing questions that focus on the tax implications of ISOs.