Updated for 2022. Develop a tax planning strategy before exercising your ISOs. Commonly referred to as equity-based compensation, the term stock options can mean an individual is given equity – or given the option to buy equity – in a number of different ways. Several tax planning strategies for incentive stock options exist, but you need a plan in place before exercising. As more companies prepare to go public via an IPO, having a strategy in place for your stock options can really pay off.
Tax Planning Strategies for ISOs
Incentive stock options (ISOs) are common in startup companies. After going public, many companies switch to restricted stock units. ISOs allow employees to buy a specific number of the company’s shares at a fixed price, the strike price, which is the market value on the grant date. The tax implications of exercising ISOs will vary depending on your strategy. So before exercising your options, it is very important to learn about tax planning strategies for incentive stock options.
Favorable Tax Treatment for Incentive Stock Options
A qualifying distribution occurs when an individual holds the shares for at least two years after the grant date and at least one year after the exercise date. After this period, when the stock is subsequently sold, the employee will pay long-term capital gains on the gain. The gain is the sale price less the grant price multiplied by the number of shares sold. Here’s an Infographic on How ISOs are taxed.
Incentive stock options have unique tax benefits as opposed to other equity-based compensation methods, such non-qualified stock options or RSUs. Unlike other types of stock options, with ISOs, there is no tax due upon exercise.
Further, if an employee meets certain holding requirements, the stock will only be taxed at favorable long-term capital gains rates when the stock is sold. But be aware – choosing to hold onto the stock for long enough to receive this favorable tax treatment does not come without a cost – it may trigger the Alternative Minimum Tax (AMT).
ISOs will not be eligible for favorable tax treatment when a disqualifying disposition occurs. If ISOs are sold within two years of grant or one year of exercise they lose favorable tax treatment. Unlike the normal holding period for financial assets where long-term capital gains tax rates apply after a year and a day, with ISOs, the shares must meet longer holding requirements for the full benefit.
A disqualifying disposition is everything that isn’t a qualifying disposition. The tax implications at sale depends on the strike price and the stock price at exercise and sale. The ‘bargain element’ is the spread between the strike price and the value of the stock at exercise. The ‘compensation element’ is taxable as ordinary income. The compensation element is the lesser of the bargain element or the actual gain from the sale.
Disqualifying disposition tax a high level:
- If the sale price is greater than the value at exercise and the strike price, the bargain element is taxable as ordinary income. The additional gain between the value at exercise and the sale price is a capital gain (short or long-term depending on your holding period after exercise).
- If the sale price is less than the value at exercise, but above the strike price, the compensation element will be the actual gain on the sale (lower than the bargain element).
- If the sale price is less than the strike price, you’ll likely have a capital loss.
Again, be sure to work with a tax preparer familiar with stock options to discuss your situation.
Employers Don’t Withhold Taxes on Incentive Stock Options
Regardless of the ISO holding period, or whether the sale is a qualifying or disqualifying disposition, employers won’t withhold tax or remit tax payments to the IRS. So when considering how to use the proceeds, remember that you may owe a substantial amount in taxes in the current year. This can be especially important during a disqualified disposition, as you will likely owe both taxes on regular income as well as capital gains. Working with a CPA to estimate your tax liability is advisable.
How Can Exercising ISOs Lead to AMT Issues?
One major drawback to incentive stock options is the potential that they may trigger the alternative minimum tax (AMT). The AMT is complex, but at a high level, it is a parallel tax calculation which disallows – or adds back – certain tax deductions and non-taxable items that individuals may be permitted to use when calculating their tax liability under the regular system.
Instead, in the AMT calculation, filers are allowed one exemption amount, which is phased out with income. Taxpayers will ultimately pay whichever number is higher; their tax liability under AMT or their regular tax liability.
Taxpayers who exercise and keep their ISOs during a calendar year may have AMT issues, as a part of this transaction must be reported as income for the AMT calculation. The bargain element is the difference between the price you pay for the shares and the valuation of the stock at exercise.
The bargain element is reported to the IRS for alternative minimum tax purposes in the year the options are exercised, unless they are sold during that year. This (sometimes drastic) increase in phantom unrealized income can leave some individuals owing thousands of dollars more in taxes than they anticipated.
If you do trigger the AMT, you’ll want to make sure to track your AMT carryforward credit to use in future years. Again, work with a CPA familiar with stock options.
Incentive Stock Options and the AMT: Ways to Reduce the Impact on Your Tax Situation
Although there isn’t always much to be done about an AMT liability, with proper planning there are ways to help offset the impact of ISO exercises on AMT.
- Estimate the impact. Before exercising incentive stock options available to you, work with a tax professional to calculate the projected impact for AMT. Based on this information, you may not want to exercise all your options at once. Or perhaps you sell some stock during the year. The stock you sell won’t be included in the AMT calculation. Further, the proceeds can help fund an existing AMT liability. To try and avoid AMT altogether, work with a CPA to calculate the number of options you can exercise in the year without your AMT exceeding regular tax due. Consider exercising early in the year and reevaluating at the end of the year (and potentially selling if the stock is publicly traded) or at the end of the year when you know the AMT outcome.
- Monitor the stock price. It can be advantageous to exercise ISOs in the beginning of the year; then, if stock prices decline from the fair market value (FMV) at time of exercise, consider selling the stock. Although this strategy will create a disqualifying disposition, it will also avoid becoming an AMT preference item. By holding onto the stock, an individual may be forced to pay AMT on a phantom gain. This is because the bargain element is based on the FMV at exercise, not current market prices.
Other Tax Planning Considerations
As you consider the role stock options play in your overall compensation package, keep in mind a couple of key points:
- Diversification. Many individuals opt to sell their ISOs upon grant in order to limit a potential downside and diversify their assets. As an employee, much of your financial stability is likely dependent on your salary and health of your employer. Consider cashing out a portion of stock compensation and investing in more diversified funds across the market.
- Stability of stock price. As with any investment, ISOs carry risk. Unstable stock prices may prevent from you from ever exercising if the stock price never exceeds the grant price. Even worse, should the stock plummet after exercise, it could even end up in a loss.
- Review your options. Before exercising incentive stock options, do your homework and find out what options may be available. Many public companies offer a cashless exercise. This is when you initiate a same-day exercise and sale of your stock options. A portion of the proceeds will be used to cover the cost of buying the stock. You’ll receive the net cash proceeds. It’s a disqualifying disposition. A net exercise is when you exercise the shares and some of the stock is held back to cover the cost of buying the stock. You receive the net shares to hold. There are different interpretations about whether a net exercise will invalidate the entire ISO grant from favorable tax treatment or not. At the very least, the shares used to buy the stock are taxable as a disqualifying disposition. Recall employers do not withhold for taxes.
There are plenty of other tax issues to consider so speak with an advisor about your situation.
Help managing your stock options
Stock options can be quite complex. If you have ISOs or other stock options, it is very important to consult your financial advisor and tax professional to determine a strategic plan for your stock options before exercising. Although there is a lot of credible general guidance online, the best approach should be specific to your personal situation. Vesting, company projections, cash on hand, and overall tax situation are just a few of the drivers influencing how and when to exercise stock options.
Darrow Wealth Management is a fee-only financial advisory firm. We regularly work with employees and executives with stock options, particularly after an IPO or acquisition. By integrating financial planning with investment management, our goal is to help busy professionals build and grow their wealth. As an independent full-time fiduciary, we have a duty to act in the sole benefit and interest of our clients. This is the highest act of loyalty, trust, and care under the law.