Selling Incentive Stock Option Shares To Accelerate Tax Credits

Incentive stock options may provide for the opportunity to pay taxes on the gain at long term capital gains rates instead of at ordinary income rates if exercised following the rules for a qualifying disposition.  Because of this potential tax advantage, many will attempt to meet the standard for qualifying in order to “save” on tax.

In practice, reaching the goal for a qualifying disposition is only the first step in tax planning. On the “front end” of incentive stock option planning, there may be tax planning opportunities to minimize alternative minimum taxes. For many, the planning ends here. But it shouldn’t.

This is because on the back end of incentive stock options, when you liquidate the stock options via a final sale, planning opportunities may also present themselves.

It’s these planning opportunities to potentially accelerate tax credits that we seek to explore today.

What is AMT?

When you exercise and hold incentive stock options, you may be subject to the alternative minimum tax (AMT). This is because the difference between the grant price of your options and the exercise price (known as the bargain element) is a tax preference item for alternative minimum taxes. In short, a tax preference item may make you liable for taxes when figuring your year-end tax return.

The impact of a large bargain element on AMT can be big. In fact, the larger the bargain element, the larger the potential taxes due because you have exercised the stock options

Owing taxes can create a difficult conundrum for those who want to exercise and hold stock options. The issue lies in whether the shareholder has enough cash on hand to pay the taxes due. This is further complicated by the fact that during an exercise and hold coupled with a cash exercise, the cash outlay may be compounded. (This potential negative cash flow in the year of exercise is why many option holders choose a cashless exercise instead of a cash exercise.)

How much tax will you owe, you ask? One oversimplified assumption is that the bargain element at exercise will be taxed at 28%.

Using a hypothetical example as an illustration, we can calculate the potential tax impact of exercising and holding incentive stock options.

Grant Price $5.00
Exercise Price $25.00
Shares 10,000
Bargain Element at Exercise $200,000
Tax Due (at 28%) $56,000

If an option holder exercises shares in the example above, it’s possible they could owe $56,000 in taxes in the year of exercise. This is cash that will need to be paid from other resources, be it cash on hand, cash from the sale of other investments, or some other source.

Exploring How To Get AMT Back

So why would I ever want to pay AMT on incentive stock options? Why wouldn’t I simply perform a disqualified disposition and have the gain between the grant price and exercise price taxed as ordinary income? Because AMT, in short, is simply a pre-payment of expected taxes due.

To state it another way, if the shares are held to the point where they qualify as a qualified disposition, the entire gain, from grant price to final sale price, may be taxed at long term capital gains rates.

To simplify, if you originally “prepaid” tax at 28% and long term capital gains rates are 15% when you perform a qualified disposition, you overpay taxes by 13%. This means that you are potentially eligible to get the overpayment of tax back in the form of a tax credit.

Continuing the example above, if we assume the price of the stock remained constant for one year and the shares were sold as a qualified disposition, we can calculate the taxes owed to be $30,000 (assuming a long term capital gains rate).

Grant Price $5.00
Exercise Price $25.00
Shares 10,000
Bargain Element at Exercise $200,000
Tax Due (at 15%) $30,000


The AMT Credit

You will remember that upon exercise of the incentive stock option, $56,000 of AMT was paid.

Upon selling the previously exercised incentive stock options as a qualified disposition, it’s time to “even up” with the IRS. Assuming long term capital gains rates of 15%, we can calculate the actual amount of tax due to be $30,000.

In our example, we can calculate an overpayment of taxes of $26,000 ($56,000 minus $30,000). This $26,000 is potentially available as a tax credit.

Maximizing AMT Credit By Exercising the “Right” Tranche

Now that we have a simple understanding of the taxation of incentive stock options, we can begin to use this understanding to accelerate AMT credits—specifically as it pertains to the final liquidation of incentive stock option shares.

From a practical standpoint, it’s not uncommon for an employee to have several tranches of incentive stock options. These tranches form as stock options are exercised at different points in time.

Often, these tranches will have difference grant prices, different exercise prices, and different spreads between the two. These different prices may create opportunity.

Let’s explore a hypothetical example (assuming all transactions will meet the standard for a qualified disposition).

Tranche Grant Price Exercise Price Final Sale Price Bargain Element AMT Tax (@28%) LTCG (@15%) Potential  Credit
1 $5 $25 $25 $200,000 $56,000 $30,000 $26,000
2 $10 $25 $25 $150,000 $42,000 $22,500 $19,500
3 $15 $25 $25 $100,000 $28,000 $15,000 $13,000
4 $20 $25 $25 $50,000 $14,000 $7,500 $6,500

If the goal is to maximize the tax credit available upon final sale, it may make sense to sell the tranche of options that included the highest AMT bargain element upon initial exercise. Or to put it another way, sell the tranche of shares that included the highest prepayment of taxes.

In our example, the highest prepayment of taxes is on the tranche of shares with the largest spread between the grant price and the exercise price, the highest bargain element.

Looking at the chart above, the tranche with the highest AMT impact upon exercise was likely tranche 1, where the grant price is $5 and the exercise price is $25. Using our same tax sample from above, tranche 1 has the opportunity to accelerate $26,000 in tax, as opposed to tranche 4, which will only accelerate $6,500.

The decision here is nearly a $20,000 difference!

What Now?

It’s not uncommon for planning to occur on the front end of incentive stock option planning, specifically strategizing how and when to exercise stock options.

But as you can see, the decision regarding which shares to sell on the back end is equally important.

In fact, depending on the value of your options and the bargain element, it’s very possible that selling the “right” tranches of stock may be the difference in accelerating a refund of thousands of dollars of taxes sooner rather than later. Using the time value of money as our guide (a dollar today is worth more than a dollar tomorrow), it only makes sense to want to accelerate cash back into our pockets as soon as possible.

Even further, a final sale of incentive stock options will create a cash inflow. What to do with the cash inflow created from liquidating concentrated equity is another massive decision in and of itself.

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.

, ,

One Response to Selling Incentive Stock Option Shares To Accelerate Tax Credits

  1. steve hayworth December 17, 2016 at 6:38 pm #

    This is really good to know. The long term capital gains rate is not automatically adjusted on exercised shares. It has to be adjusted based on the amount of bargain

Leave a Reply