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ISOs vs NSOs: Taxes & Risks to be Aware of · The Wealth Cafe

• 0:15
  SPEAKER_00: For so many high earners, whether you're working in tech, a startup, or a more established company, one of the biggest pieces to building wealth and understanding your compensation is maximizing any type of equity you are offered by your employer.
• 0:30
  SPEAKER_00: So today I want to take some time on this episode of The Wealth Cafe to break down two really important pieces that come into play when looking at stock options.
• 0:38
  SPEAKER_00: Now, depending on where you are in your journey, your career, things are gonna look a little different.
• 0:44
  SPEAKER_00: So make sure you are working with your accountant, your financial planner, and your estate attorney to figure out what makes the most sense for you because there are so many different pieces and tax implications when it comes to maximizing what you have and fully understanding the different options that are available to you.
• 1:00
  SPEAKER_00: Now let's dive in to first talking about what actually is a stock option.
• 1:06
  SPEAKER_00: I always like to tell people, think option.
• 1:09
  SPEAKER_00: You have options easier said than done, right?
• 1:12
  SPEAKER_00: However, when you have a stock option, it really means that you have the ability to purchase shares in your company.
• 1:18
  SPEAKER_00: It doesn't mean you actually have those shares.
• 1:21
  SPEAKER_00: For example, let's say you are given a hundred options of ABC stock.
• 1:26
  SPEAKER_00: That doesn't mean you actually own a hundred shares of that ABC stock.
• 1:30
  SPEAKER_00: I always like to give that caveat because I will have so many prospective clients that come into my office and say, Caroline, I actually have a hundred shares of stock in my company.
• 1:40
  SPEAKER_00: Here's the value, here's what it's worth.
• 1:42
  SPEAKER_00: But then I start looking through the paperwork and we start to see that actually, rewind, you have options, not just the actual shares.
• 1:49
  SPEAKER_00: Like I said, today we are going to focus on options.
• 1:52
  SPEAKER_00: We have other episodes also coming down the road where we'll talk more about RSUs, the different vesting behind it.
• 1:57
  SPEAKER_00: But today let's focus on options and the two different types that are part of that process.
• 2:03
  SPEAKER_00: And I want to start first by laying out some lingo for you so we all are on the same page because everyone comes from a different background in terms of education.
• 2:10
  SPEAKER_00: So let's break down a couple different terms when it comes to looking at stock options.
• 2:15
  SPEAKER_00: Let's start with a few terms that everyone should know before we dive into the minute details of this episode.
• 2:20
  SPEAKER_00: First off is your grant or strike price.
• 2:23
  SPEAKER_00: You may see those used interchangeably on any documentation that you are given.
• 2:27
  SPEAKER_00: The grant or strike price is the price that you can actually purchase the stock for.
• 2:32
  SPEAKER_00: So let's say that your company's stock is publicly traded and you see that it's trading for$20, but you have a strike price or a grant price of$15.
• 2:41
  SPEAKER_00: That means that you have the option or the right to purchase that company stock at$15 rather than the$20 that it is typically traded at on an open market.
• 2:51
  SPEAKER_00: The second term to know is your vesting schedule.
• 2:54
  SPEAKER_00: Now, vesting schedule doesn't mean that you are then given the stock on that date.
• 2:58
  SPEAKER_00: It means you are given the options on that date.
• 3:01
  SPEAKER_00: I want to give you a quick example to break it down.
• 3:03
  SPEAKER_00: Let's say you have a hundred options that have a four-year vesting schedule.
• 3:08
  SPEAKER_00: That means every year you will be given 25 options.
• 3:11
  SPEAKER_00: That means on that anniversary date, whatever is listed out in your compensation, 25 of those options will then be given to you.
• 3:18
  SPEAKER_00: And you then have the ability to go in and purchase those 25 shares once they are vested to you.
• 3:25
  SPEAKER_00: The third term to break down is exercise.
• 3:27
  SPEAKER_00: That means actually using the options.
• 3:30
  SPEAKER_00: If you don't exercise your options, they typically expire worthless.
• 3:34
  SPEAKER_00: You don't put up any money, they just kind of disappear into the night.
• 3:37
  SPEAKER_00: However, when you decide to exercise your options, I'm gonna go back to the example before of you have a company stock trading at$20, but you have the option to purchase it at 15.
• 3:47
  SPEAKER_00: When you decide to go forth and purchase those shares, aka exercise, you would then say, okay, I'm ready to pay my$15 times 25 options.
• 3:57
  SPEAKER_00: I'm ready to put up that money and actually have those shares into my possession rather than just the options.
• 4:03
  SPEAKER_00: Think of it almost as the exchange of saying, I don't want to just have the options or the ability, I want to actually take possession of those shares.
• 4:10
  SPEAKER_00: And the fourth and final term is sale.
• 4:12
  SPEAKER_00: That is when you actually decide to release the shares that you have.
• 4:16
  SPEAKER_00: If you have a publicly traded stock that you've come into possession of, it's a little easier to do, and we'll talk a little bit more about this later in the episode because you can go on to whatever trading platform you are using, sell the shares.
• 4:29
  SPEAKER_00: You do still need to be mindful in there if you are still an employee or whatever terms you have, because there may be things like blackout dates, aka times when you can't sell the shares.
• 4:38
  SPEAKER_00: You may have a holding or waiting period, aka you may not be able to sell those shares for a period of time.
• 4:44
  SPEAKER_00: So make sure you also understand, unfortunately, there isn't typically a one size fits all in terms of, hey, you have to wait this long or you can't sell during these dates.
• 4:54
  SPEAKER_00: Every company is unfortunately different.
• 4:56
  SPEAKER_00: And when you are dealing with private companies, it becomes a little more difficult because you can't just go onto whatever platform, see what the sale price is, see what your proceeds are.
• 5:05
  SPEAKER_00: It's a little more complicated because you would have to find out what actually is the company being valued at.
• 5:10
  SPEAKER_00: How do I trade and sell my shares and how do I exit?
• 5:14
  SPEAKER_00: It can't, it's not that it can't be done, it just has a little bit more nuance and complication, and you need to understand the process on a deeper level.
• 5:21
  SPEAKER_00: Now let's break down the two different types of stock options that we have.
• 5:25
  SPEAKER_00: First is ISO's aka incentivized stock options.
• 5:29
  SPEAKER_00: These are stock options that can only be given to employees.
• 5:33
  SPEAKER_00: That's a big thing to note.
• 5:34
  SPEAKER_00: You have to be a W-2 employee of the company in order to qualify for these options.
• 5:39
  SPEAKER_00: A key thing to note about incentivized stock options is that they have preferential stock treatment.
• 5:44
  SPEAKER_00: I'll dive into a little later in this episode what that actually means and what to know about it.
• 5:49
  SPEAKER_00: However, that's the key thing that you need to know when looking at ISOs versus NSOs.
• 5:54
  SPEAKER_00: So, what is an NSO?
• 5:56
  SPEAKER_00: That's the second type of stock option that we are looking at.
• 5:59
  SPEAKER_00: An NSO is a non-qualified stock option.
• 6:02
  SPEAKER_00: And another big thing to note about this type of option, it's not just for employees.
• 6:06
  SPEAKER_00: So let's say you serve on a board as a consultant, or let's say you are also a 1099 contractor for an employer.
• 6:14
  SPEAKER_00: It's gonna look a little different because you could actually get non-qualified stock options.
• 6:18
  SPEAKER_00: You cannot, though, if you're just a board member or advisory or a consultant on the 1099 side, you cannot get the ISOs.
• 6:26
  SPEAKER_00: Two big things to note in the difference there.
• 6:28
  SPEAKER_00: The other big thing to compare the two different types of options is the way that they are treated in terms of taxes.
• 6:33
  SPEAKER_00: I'm gonna give you an example for the NSOs to explain how they are taxed.
• 6:38
  SPEAKER_00: Essentially, they are taxed at your income rate.
• 6:41
  SPEAKER_00: So let's say that you are given shares and have the option to purchase shares, the options, at$15 is what they are trading at at a fair market value.
• 6:51
  SPEAKER_00: However, you are going to purchase them at$10.
• 6:55
  SPEAKER_00: You have a$5 difference there.
• 6:57
  SPEAKER_00: That$5 difference for every share, let's say you get 100 shares.
• 7:00
  SPEAKER_00: So we're looking at a$500 difference.
• 7:03
  SPEAKER_00: That$500 is going to be taxed at ordinary income.
• 7:07
  SPEAKER_00: So what happens when you go to sell these shares?
• 7:09
  SPEAKER_00: Because you may not just sit on them forever unless you're gonna pass them to the next generation, which is an entirely different topic.
• 7:15
  SPEAKER_00: But let's say that you are going to sell these shares.
• 7:18
  SPEAKER_00: There's two different ways that this can occur from a taxation standpoint.
• 7:21
  SPEAKER_00: I'm gonna give you an example.
• 7:23
  SPEAKER_00: Let's say that in two years, you decide I'm going to sell these shares.
• 7:27
  SPEAKER_00: If you wait over two years, you are going to be taxed at long-term capital gains rates.
• 7:32
  SPEAKER_00: So that's either 15 or 20% depending on your tax bracket.
• 7:36
  SPEAKER_00: Make sure you look it up for that year, depending on what your income is.
• 7:39
  SPEAKER_00: You can check that out on the IRS website to figure out if you'll be 15 or 20% long-term capital gains.
• 7:45
  SPEAKER_00: However, if you wait for less than one year, that will then get added to your ordinary income and you'll have a short-term capital gain in there.
• 7:54
  SPEAKER_00: So that will add to your ordinary income.
• 7:56
  SPEAKER_00: So it's something to be mindful of is how long you are waiting to sell those shares.
• 8:00
  SPEAKER_00: Now, this is a key component to NSOs, is that you have really two pieces of taxation.
• 8:06
  SPEAKER_00: You are taxed on the difference when you had that$15 versus$10.
• 8:11
  SPEAKER_00: So we had that$500 that you are paying the ordinary income tax on.
• 8:16
  SPEAKER_00: And then you also have whenever you fast forward in time to fully sell your shares, whether that's two years, 10 years, or if you are on the short-term side, and that will get added more to your ordinary income.
• 8:26
  SPEAKER_00: So there are two big pieces when it comes to understanding your taxes for NSOs.
• 8:32
  SPEAKER_00: And that's something to be mindful of and to really work with your financial planner and your tax team is to look at, okay, when are we selling the shares?
• 8:39
  SPEAKER_00: Another big thing to look at is you don't always have to sell your shares all at once.
• 8:43
  SPEAKER_00: If you are on a vesting schedule and things are vesting and you're exercising your options at different times, you can then say, hey, let's just sell shares from certain lots to help from a tax strategy advantage.
• 8:55
  SPEAKER_00: And you may also say, hey, maybe there's some losses in here that we can take.
• 8:58
  SPEAKER_00: There's a lot of different options to keep in mind as you're going through the process, but keep in mind with NSOs, there are two big times when you are paying the taxes, when you are exercising your options and when you are selling.
• 9:11
  SPEAKER_00: Now, let's talk about how ISOs are treated in terms of taxation.
• 9:15
  SPEAKER_00: ISOs are treated differently than NSOs.
• 9:18
  SPEAKER_00: Now, we need to keep in mind a couple different nuances with ISOs here because you want to hit some qualifying events in order to get the preferential tax treatment.
• 9:27
  SPEAKER_00: And that is a big deal here.
• 9:28
  SPEAKER_00: That is what people look for in ISOs.
• 9:30
  SPEAKER_00: That's why a lot of employees favor them because you can have this preferential tax treatment.
• 9:35
  SPEAKER_00: When you actually exercise your options, you don't pay any capital gains tax or it's not added to your ordinary income on the difference of the stock price.
• 9:45
  SPEAKER_00: So let's say, once again, going back to our example, the stock is at 15, you pay 10, that$5 difference times the number of shares is not added to your ordinary income.
• 9:55
  SPEAKER_00: However, depending on what your ordinary income is, it may be added to your AMT.
• 10:00
  SPEAKER_00: Now, AMT stands for alternative minimum tax, and this is where you need to work with a great accountant and your financial planner to bring them in and consult and say, hey, is my exercising of these options going to add to my AMT?
• 10:12
  SPEAKER_00: Am I going to create what's called a phantom stock bill?
• 10:15
  SPEAKER_00: What can we do here to use strategy?
• 10:17
  SPEAKER_00: This is where it depends, situation versus situation.
• 10:20
  SPEAKER_00: And you need to have a great financial team to help you navigate this situation because as I'm going to dive into in a moment, this can be a great event to help you if you hit these qualifying events for taxation purposes.
• 10:33
  SPEAKER_00: Now, when it comes to ISOs, there are two important things that you need to hit and make sure you are paying attention to in terms of taxation.
• 10:41
  SPEAKER_00: The first of which is that you need to make sure that you are holding the shares for one year after your exercise date.
• 10:49
  SPEAKER_00: The second piece is that you need to make sure that you are holding the shares for two years after the grant date of the options.
• 10:55
  SPEAKER_00: This is when it is so important to make sure you have documentation, all of the pieces from HR and the communications of showing when did the dates actually happen, keeping everything in order to make sure you get that preferential tax treatment.
• 11:08
  SPEAKER_00: What is that preferential tax treatment?
• 11:10
  SPEAKER_00: It's actually getting long-term capital gains.
• 11:12
  SPEAKER_00: So that 15 or 20% versus having this hit your ordinary income, which is a big deal, especially for my high earners out there, where this could be added to your ordinary income and pushing you into another tax bracket, that 15 or 20% can make a big difference.
• 11:28
  SPEAKER_00: This is when you need to work with your financial team, make sure you have a strategy in place and are documenting everything to be prepared for that moment.
• 11:36
  SPEAKER_00: Another important nuance you need to understand about ISOs, especially if you have a lot of your compensation that is being given to you in ISOs, is the$100,000 rule.
• 11:45
  SPEAKER_00: Breaking this down, this means that$100,000 of ISOs cannot be vested to you more than one year.
• 11:52
  SPEAKER_00: So if you have$110,000, that extra$10,000 will automatically become an NSO.
• 11:59
  SPEAKER_00: Why does that matter and who cares?
• 12:01
  SPEAKER_00: Well, two big things.
• 12:02
  SPEAKER_00: Number one, that's going to change things from a tax perspective.
• 12:05
  SPEAKER_00: And number two, that's going to change the strategy and the way you understand things from how am I planning for this in my future?
• 12:11
  SPEAKER_00: When would I sell?
• 12:12
  SPEAKER_00: How would I manage them?
• 12:13
  SPEAKER_00: What are the different dates I need to hold on for?
• 12:16
  SPEAKER_00: Because as I mentioned before, it changes things in terms of ordinary income, long-term capital gains rates, and then having that strategy for the future and for the long term.
• 12:25
  SPEAKER_00: Now, to close out this episode, I want to break down for you four common mistakes that I see so many people make around ISOs and NSOs because I don't want to see you make them.
• 12:34
  SPEAKER_00: And they're just things to be mindful of as you are starting this process, or maybe you are in the thick of it now.
• 12:40
  SPEAKER_00: The first one is not modeling out your AMT and having your accountant show you, hey, what does it look like if the ISOs are to hit my AMT, and that is to raise things.
• 12:49
  SPEAKER_00: What does the future look like?
• 12:51
  SPEAKER_00: What does this single year look like?
• 12:53
  SPEAKER_00: How are we planning for now and into the future?
• 12:55
  SPEAKER_00: Because as I say time and time again, we don't want to pay the lowest tax in one year.
• 13:00
  SPEAKER_00: We want it to be in our lifetime.
• 13:01
  SPEAKER_00: And what does that mean in terms of your ISO or NSO compensation?
• 13:05
  SPEAKER_00: The second mistake that I see people make is with NSOs, they don't plan on, hey, this ordinary income bump could push me into a new tax bracket.
• 13:14
  SPEAKER_00: Once again, we know tax brackets are marginal, so it won't be across the board.
• 13:18
  SPEAKER_00: But are you prepared to either pay those taxes out of pocket, or do you have a strategy on how you can make up for it in different parts of your life and your financial plan in order to prepare for that ordinary income hit?
• 13:31
  SPEAKER_00: The third thing that a lot of people don't prepare for is what happens now that you are a owner and a lot of people start to build up concentrated positions is what happens if there is an IPO for my private company holders or if there's an acquisition, or I've also seen now several companies that go from public to private.
• 13:47
  SPEAKER_00: What does that look like for your future, for your long-term financial plan?
• 13:51
  SPEAKER_00: They aren't thinking as much about that and they don't realize this concentrated stock position could have a large impact if a lot of those moving pieces are to happen.
• 13:59
  SPEAKER_00: And the last thing is once again, back to having a concentrated stock position.
• 14:03
  SPEAKER_00: Once you have ISOs and NSOs and you start exercising those options, you can start to really build up a concentrated stock position.
• 14:10
  SPEAKER_00: And people don't realize how that impacts their net worth.
• 14:13
  SPEAKER_00: They get excited saying, hey, look at this thing that's adding to my compensation.
• 14:17
  SPEAKER_00: And while I think it's fantastic to have this added in and to have a new piece of building wealth and into your financial plan, it's something that, just as I said, you need to plan for financially.
• 14:27
  SPEAKER_00: You need to have strategies on are we going to diversify out of this?
• 14:30
  SPEAKER_00: What happens if you do have, like I mentioned before, an IPO, an acquisition, or a big moment where, hey, I actually need to sell these shares for a life event, like kids going to college, retirement, whatever it might be.
• 14:42
  SPEAKER_00: And when you have so much of your compensation or of your net worth tied up in a single stock or in multiple stocks, it can be a volatile market when we see things happening.
• 14:53
  SPEAKER_00: And that can have a major impact on yes, your net worth, but also your emotions, right?
• 14:58
  SPEAKER_00: Money is emotional, and that is something that we need to consider.
• 15:01
  SPEAKER_00: And a lot of people just ignore that and they get excited saying, Oh my goodness, I have this money, I have this compensation, this is awesome.
• 15:08
  SPEAKER_00: But are you planning and preparing for it?
• 15:11
  SPEAKER_00: What do you do from here?
• 15:12
  SPEAKER_00: Stock options can be incredibly valuable.
• 15:15
  SPEAKER_00: They are something that needs to be planned for, talked about from a taxation standpoint, from a financial planning standpoint, and also from an estate planning standpoint.
• 15:24
  SPEAKER_00: You need to make sure you're working and bringing all of these pieces together because this can be such an exciting time.
• 15:29
  SPEAKER_00: It can be an amazing way to build wealth, but it needs to be done so strategically.
• 15:34
  SPEAKER_00: I have seen so many people that have fumbled this moment because they don't want to plan for it, they don't want to prepare for it, they just think, cool, this is the way things are meant to be.
• 15:42
  SPEAKER_00: But this is a great time to get things done strategically.
• 15:46
  SPEAKER_00: If you have questions, if you know somebody that has questions about these big life events, if you're going through an acquisition, a merger, getting ISOs, NSOs, or know you will be in the future, reach out and we can always schedule an introductory call at tannisfingroup.com and talk more about this and building your financial team to help you build wealth and prepare for the future around these exciting events rather than this causing turmoil, stress, or anything that causes you to be unsure and uncertain about the future.
• 16:15
  SPEAKER_00: Thanks for tuning in to this episode of The Wealth Cafe, and I look forward to seeing you again next time.