4 Strategies for Exercising your ISOs, and the Tax Impact

ISO's and stock options

How do Incentive stock options work

Incentive stock options (ISOs) may be offered as part of an employee compensation package.  In a best-case scenario, they may offer a potentially invaluable benefit to employees. 

In fact, if an employee is offered incentive stock options at a low grant price (the grant price is the price of the stock at the day of issuance and is the employee’s purchase price) and the stock price increases substantially, it may be possible for the employee to earn a large amount of money.

For a hypothetical example, let’s say an employee is issued 1,000 incentive stock options with a grant price of $10 per share and that after the grant date, the price of the shares increase to $250 per share.

Using simple math, we can calculate that each stock option is worth $240. This means that the employee could buy the share at $10 then immediately turn around and sell each share for $250. If the employee has 1,000 shares, multiplied by $240 per share, the employee could make $240,000!

However, even though the math is simple, incentive stock options are not.  Alternative minimum tax, qualified and disqualified distributions, cash vs. cashless exercise, and ordinary income vs. long term capital gains are only some of the factors that need to be considered when evaluating a strategy to exercise incentive stock options.

Most of what makes these stock options so complicated is the many possible exercise scenarios available to the incentive stock option holder.  Depending on the grant date of the ISOs, when they are exercised, and when the sale of these shares occur, incentive stock options may have wildly different after-tax values.

Let’s take a look at some more common options:

Option 1 – Exercise Your Shares and Hold Them

WHY – The decision to exercise and hold could be the right option for many reasons. Most notably, this option could be for someone who is seeking to maximize the tax benefit of incentive stock options by meeting specific holding periods. Option 1 needs to occur to reach option 4.

If you choose to exercise your shares and hold them, the only income that needs to be reported in the year of exercise is known as the bargain element. The bargain element is calculated as the value between the grant price of the options and the price upon exercise.

Using the hypothetical example above, with a grant price of $10 per share and an exercise price of $250 per share, the bargain element will be $240 per share ($250 minus $10 = $240 per share).

Now, assume you have 1,000 options. At $240 per share, you would have a total bargain element of $240,000.

The bargain element is an adjustment to the alternative minimum tax (AMT) on your personal tax return.  While the scope of AMT is beyond this article, it’s important to know this adjustment may materially impact your tax return and taxes you owe at the end of the year. An accountant would be able to help with the details.

After exercising the shares, you own them outright and are subject to the risks associated with owning an individual stock position.

Option 2 – Exercise Your Shares and Sell them Immediately

WHY – For someone who is seeking to diversify* their stock options as quickly as possible, an exercise and sell may be the most suitable option. This option can be implemented as early as the options are vested, as late as the last day prior to expiration, or anywhere in between. The option to exercise and sell immediately means the “in the money” value of your options will be taxed as ordinary income.   

In lieu of holding the stock after exercise (as is the case with option 1), the decision is made for this option to sell the stock on the same day as the exercise (removing the aforementioned risk associated with an exercise and hold).

In this scenario, the entire amount of the gain will be subject to ordinary income tax rates.  In the above example, the entire $240,000 gain will be taxed as ordinary income. Assuming a 33% tax bracket, this transaction would lead to a $79,200 tax liability.

While this tax liability may seem large, it’s important to remember that the person who is choosing to sell immediately has identified investment diversification* as more important than taxes owed.

It’s equally important to note that we are using big numbers, and if you earn a higher wage, you currently would pay more in taxes.

Option 3 – Disqualifying Sale – Anything other than a Qualified Sale (see option 4)

Why – A disqualifying sale can occur intentionally (as is the case with option 2) or unintentionally (for someone who is seeking to make a qualified sale but, for one of many potential reasons, does not).

In short, a disqualifying sale effectively turns ISOs into non-qualified stock options by taking what is potentially taxed at a long term capital gains rate and making it taxed as ordinary income.

You may be interested in holding the stock beyond the exercise date,  however for any number of reasons, you may be forced to sell early.

If the decision is made to sell, and this sale occurs before the qualifying period detailed in option 4, the sale will be a disqualified sale. A disqualified sale may lead to AMT, AMT adjustments, short term capital gains, and long term capital gains.

Specifically, an AMT adjustment per option 1 could occur in the year of exercise.

In the year following the year of exercise, if we assume a sale of stock will occur within one year of exercise, the seller will have two things to report.

First, they will need to report a short term capital gain (or loss) on the difference between the exercise price and the sale price. They will also need to report an AMT adjustment. This adjustment effectively offsets the AMT adjustment from the previous year.

Option 4 – Qualifying Sale – Sell Your Shares 1 Year After Exercise or 2 Years After Grant (whichever is longer)

Why – This option is for someone who has met the holding requirement of incentive stock options that entitles them to long term capital gains treatment on the difference between the original grant price and the final sales price, maximizing the total after tax value of the transaction.

A “qualifying sale” occurs when the recipient of incentive stock options exercises shares more than one year after exercise and sells the shares and more than two years after grant.

If the rules of a qualifying sale are met, the difference between the grant price and the final sales price is treated as a long term capital gain.  A long term capital gain may take advantage of preferential tax treatment.

In our hypothetical example, the basis of the shares of stock will be $10,000 ($10 per share times 1,000 shares).

The sales price will be $250,000 ($250 per share times 1,000 shares).

Please note that we have made an extreme assumption that the share price will not move at all between the exercise date and the sale day at least one year later, but this is just an example for illustrative purposes only and does not attempt to predict actual results of any particular investment.

This hypothetical gain of $240,000 will be taxed as long term capital gains.

As for the potential impact of a qualified sale, if we assume a 15% tax bracket on the gain, we can calculate a tax liability of $36,000 (15% times $240,000).

This $36,000 tax liability is compared to the ordinary income tax treatment of $79,200 as calculated in option 2. The difference of $43,200 is effectively the opportunity cost (and risk) of holding concentrated equity.

Anything But Easy

Incentive Stock Options (ISOs) may have the distinct advantage of being eligible for favorable long term capital gains treatment if exercised appropriately.  However, risk must be assumed by the shareholder.  Most notable is the risk of holding potentially large positions of concentrated equity.

As always, a plan to address the upside and downside of holding stock is key. In addition, understanding how stock options fit into your financial plan and your tax plan is key to developing a hold or a liquidation strategy. Personal goals and objectives also need to be considered when evaluating which option is best.

* Diversification does not guarantee a profit or protect against a loss.

Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts. 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.

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