Get to know the authorAt tech companies, startups, large publicly traded companies, and many other employers, incentive stock options (ISOs) are a common offering. If you’re a US expat with ISOs, you may stand to benefit financially from them in a significant way — especially if you keep ISO taxation in mind.
The way the US taxes ISOs can be complex, but understanding these tax implications is essential. Exercising and selling ISOs without planning for taxes can take a significant bite out of your gains. A smart ISO tax strategy, on the other hand, ensures you get to keep as much of your earnings as possible.
Read on below to learn what ISO taxation involves, how it affects your reporting obligations, how to minimize your tax bill, and more.
What are ISOs?
ISOs are a benefit that allow employees to purchase company stock with two distinct advantages:
- The purchase price of the stock is set in advance, often resulting in a discount
- The profits from selling the stock can potentially receive favorable tax treatment under certain conditions
ISOs are most commonly issued by publicly traded companies or private companies planning to go public. Employers typically reserve ISOs for executives or other highly-valued employees, such as members of management or those with highly specialized skill sets.
B!T note: While foreign companies may offer similar equity compensation programs, ISOs are a benefit specific to US-based companies.
How do ISOs work?
Employers often include ISOs as part of an employee’s initial compensation package. However, they may also grant them upon an employee’s promotion, after a certain period of employment, or under other circumstances.
ISO agreements stipulate the conditions under which employees may exercise their stock options or choose to purchase them. The date an employee is allowed to exercise their options is known as the exercise date.
Vesting schedules
ISOs can vest — or become eligible to exercise — in a number of different ways. Often, ISOs vest gradually over a period of three to five years. This incentivizes employees to stay with their employer until they can exercise all of their ISOs.
Other times, ISOs may vest all at once, contingent upon a certain goal or event like an initial public offering (IPO). In rare cases, they may vest immediately.
Let’s take a closer look at one of the more common vesting schedules: a graded four-year vesting schedule with a one-year cliff.
Example: Omar, an expat living in Argentina, signs a remote job offer to be the CTO at a US-based startup. As part of his compensation package, they include ISOs. None of those ISOs will vest until he has been working at the company for one year, known as the cliff period.
On his one-year job anniversary, 25% of his ISOs will vest. From that moment on, the remaining 75% of his ISOs will vest at a rate of 1/36 (about 2.08%) per month. After three more years — or four years of employment total — 100% of his ISOs will have vested.
Exercising stock options
ISO agreements define the price at which employees may purchase stock options, which is called the strike price or exercise price. Employers typically set the strike price at the fair market value (FMV) of the stock on the grant date.
B!T note: ISOs are subject to strict tax rules and regulations. If a company doesn’t properly price or structure them, they may fail to qualify as ISOs. In such cases, the IRS may classify them as deferred compensation under Section 409A, which can result in higher taxes and even penalties.
Employees may purchase stock options as soon as their ISOs vest. In some cases, though, they might choose to wait, such as if the shares of stock have an FMV below the strike price. Waiting before selling can also help you avoid triggering the Alternative Minimum Tax (AMT), which we’ll discuss in more detail later.
Most ISOs also contain an expiration date or a date on which you can no longer exercise your vested ISOs. Typically, this is ten years after the grant date. After purchasing stock options, employees can technically sell them immediately — but doing so results in a less favorable tax treatment.
ISO tax implications by stage
The way the IRS taxes ISOs varies from stage to stage. Receiving ISOs is not a taxable event, nor is vesting. However, selling them — and exercising them can have certain tax implications.
Exercising ISOs
Unlike NSOs, exercising ISOs doesn’t have ordinary income tax implications. However, it can have AMT implications.
This is because the difference between the strike price and the FMV of the shares at the time of exercising — also known as the bargain element — counts as income for AMT purposes. As such, it’s possible that exercising ISOs can push you over the AMT threshold or increase your AMT liability.
After exercising your ISOs, you’ll receive a Form 3921 from your employer. If you’re subject to the AMT, you’ll need to report the bargain element on Form 6251.
Selling shares acquired through ISOs
Selling shares purchased through an ISO agreement is a taxable event any way you slice it. However, the exact way the IRS taxes these sales depends on whether they count as qualifying or disqualifying dispositions.
Profits from qualifying dispositions are subject to long-term capital gains tax rates of 0%, 15%, or 20%, depending on your overall taxable income. To receive this favorable tax treatment, you must wait to sell shares acquired from ISOs until:
- At least two years after the grant date, AND
- At least one year from the exercise date
If you don’t meet both of those criteria, the sale will count as a disqualifying disposition. In this case, the bargain element will be included in your adjusted gross income (AGI) and taxed at ordinary income tax rates (10% to 37%, depending on the overall tax bracket).
If you held the shares for a year or less before their sale, gains are subject to short-term capital gains rates (10% to 37% — just like ordinary income rates). If you held the shares for over a year before selling, any additional gains (besides the bargain element) are subject to long-term capital gains tax rates (0%, 15%, or 20%).
Once you sell shares, you’ll need to report them on Form 8949, Schedule D, and your primary tax return (usually Form 1040).
Tax planning strategies for ISOs
There are a few different ways you can mitigate tax liability associated with ISOs, which will help you maximize your earnings.
AMT planning & management
Those with a significant amount of ISOs — especially if they’re already high earners — will need to navigate AMT implications carefully. As we mentioned earlier, exercising ISOs will add the bargain element to your AGI for AMT purposes, which has the potential to trigger the AMT or increase your AMT liability.
As a result, you’ll need to think carefully about when to exercise your ISOs. Unless you’re significantly under the AMT threshold, it’s often a good idea to avoid exercising a large number of ISOs at once. Instead, you might consider exercising your ISOs:
- Little by little over several years
- During years where large increases in ordinary income make it more likely you will be subject to ordinary income tax rates vs. the AMT
- When the stock price dips, but will likely recover
- At the beginning of the tax year when you plan to — or think you might need to — sell the shares in the following tax year
However, you’ll want to avoid exercising ISOs during years where large capital gains can push you over the AMT threshold or increase your AMT liability.
Timing sales
To receive the most favorable tax treatment, you’ll need to strategically time when you sell shares acquired through ISOs. Qualified dispositions receive the biggest tax benefits, requiring holding periods of at least two years after the grant date and one year from the exercise date before the sale.
At the very least, you should try to hold onto your shares for at least one year after the exercise date. If the sale occurs before two years after the grant date, it will count as a disqualifying disposition. As such, the bargain element will be included in your AGI and subject it to ordinary income tax rates.
However, the actual gains will be subject to the more favorable long-term capital gains rate vs. ordinary income tax rates, which can result in as much as a 17% tax bracket reduction.
83(b) elections
If your company allows you to exercise your ISOs early (more likely to occur at pre-IPO companies), an 83(b) election may help you mitigate your ISO tax burden.
When exercising your ISOs early, the bargain element (again, the difference between the strike price and the FMV) will still be subject to the AMT. However, given that most stocks increase in value over time, the bargain element will likely increase over time as well. The longer you wait to exercise, the more likely it is for your AMT exposure to increase.
To make an 83(b) election, you must submit a signed, completed 83(b) election form within 30 days of the early exercise. Make sure to include your:
- Name
- Address
- Social Security Number (SSN)
- Number & type of shares granted/purchased
- Employer name
- Date the shares were granted/purchased
- FMV on the date granted/purchased
- Amount paid for shares
- Your gross income
You’ll need a copy for your employer as well. It may also be a good idea to include a cover letter and a stamped, self-addressed envelope.
Special considerations for US expats
As an expat, there are a few additional considerations you’ll need to keep in mind:
Double taxation
If you’re a tax resident of another country, your ISOs may also have tax and reporting implications there. As a result, you could potentially have to pay taxes on the same income to two different countries.
While income tax treaties between the US and certain foreign countries eliminate the risk of double taxation, in theory, the Saving clause greatly limits their benefits. As a result, it’s usually better to leverage a different strategy, like the Foreign Tax Credit (FTC).
The FTC gives you dollar-for-dollar US tax credits on any foreign income taxes you’ve paid. If you live in a country with higher tax rates than the US, this can often erase your US tax liability entirely or even give you surplus credits to use in the future.
Country-specific tax planning
ISOs receive favorable tax treatment in the US, but most often, other countries don’t treat them the same. To understand and mitigate the tax impact of ISOs in your country of residence, you’ll likely need to consult an in-country tax specialist for advice specific to your situation.
Foreign currency conversion
When reporting your ISOs in your country of residence, you’ll need to convert their USD value into the local currency. Wise has a great currency converter tool that allows you to convert dozens of forms of global currency according to historical exchange rates.
Expat reporting obligations
If you sell shares acquired through ISOs and store the proceeds in a foreign bank account, you may need to file a couple of additional reports. This includes the:
- Foreign Bank Account Report (FBAR): Anyone whose total foreign account holdings exceeded $10,000 at any point in the year must file FinCEN Form 114, aka the FBAR
- Statement of Specified Foreign Assets: Expats whose foreign holdings exceed $200,000 on the last day of — or $300,000 at any point during — the tax year must file Form 8938 (thresholds vary for those who file jointly or reside in the US)
Resources:
- Incentive Stock Options (ISO): Definition and Meaning
- The Different Types of Equity Compensation You Need to Know
- Filing taxes for your incentive stock option plan (qualified)
- Tax Planning Opportunities For Executives with Incentive Stock Options Strategies
- A Timeline of Events for Your Incentive Stock Options
- 83(b) elections
- Granting Equity to Foreign Employees: The Ultimate Guide for Global Teams