ISO Strategies: ISOs, AMT and Long Term Capital Gains
In this piece we will be discussing tax implications and opportunities of ISOs, or Incentive Stock Options. If you need a refresher on the basics of ISO or NSOs, you can find that here.
If you sell an asset for a gain, most likely there are going to be taxes due. It doesn't matter how you acquired the asset (gift, employer, option, inheritance, etc.).
With ISOs there are three primary paths one can take:
1. Exercise and Sell, simultaneously (aka “Cashless Exercise”)
2. Exercise and Hold
3. Nothing/waiting/holding.
Tax implications and opportunities of each scenario are laid out below.
Exercising and Selling (same day, or within a year)
Exercising an ISO is acting on your right to purchase stock at a set price. The holding period starts on the day of exercise. If you sell the stock that day, or any time during that same calendar year, the sale will be treated as a short-term capital gain. Short-term capital gains are taxed at ordinary income tax rates. Note that this tax applies to the entire gain – the difference between the final sales price and the grant/strike price. There isn't much nuance here, it is the same exact tax impact if you were to purchase any stock and sell it within the same calendar year - ISO or not. Alternative minimum tax (AMT) doesn’t usually come into play for ISOs exercised and sold within the same calendar year.
Note that the same tax treatment will take place if you make the sale within 365 days of the exercise (short-term capital gain), though if you hold the shares over two separate calendar years that may bring AMT tax into play. This causes the exercise & sale transaction not to be as “clean”. If you would like to learn more about AMT, you can read this article here.
Example: As an early employee you were granted 1,000 ISOs at $2 strike price per share. Since the shares are fully vested, the total cost to exercise (purchase) is $2,000 (1,000 shares x $2). You've been with the company for a while, and the fair market value has grown to $12 per share. The value of your shares now totals $12,000 (1,000 shares x $12 value). $2,000 is the total cost to acquire, $12,000 is the total value, that means the difference, or spread, is $10,000 or $10 per share.
If you did a "same-day exercise and sale" to lock in the gain of $10,000, you would usually end up with $10,000 in your pocket before taxes. Clean and simple. The only nuance is that you are typically on your own for the corresponding tax payments, since your employer usually won't withhold income taxes through your paycheck for this transaction. Depending on your tax situation, you might have to send a payment to the IRS and your State.
Exercising ISOs (and holding onto the stock)
The first question is, why would you exercise and hold the shares? Selling any stock at a gain that you've held onto for more than 1 year is taxed at a lower (better) rate than if you held it for less than one year, all else equal.
How much do you save in taxes by holding for more than a year? It depends, but we will use a 10% difference for this example below.
Example: A $10,000 gain if you held the shares for under a year? 30% tax rate. Held it for over a year? 20% tax rate. Saving 10% in taxes may or may not seem like a lot, but it can certainly add up. That's $10,000 of tax savings on a gain of $100,000. And it is $50,000 of tax savings on a gain of $500,000.
Note: In addition to holding exercised ISOs for 1 year, technically you also need to hold them until you've reached 2 years after the initial grant date. For many situations this is a non-issue since there is often a 1-year cliff before any exercising is allowed in the first place; a 1-year cliff plus 1 year of holding post exercise adds up to 2 years.
Paying 10% less in tax sounds great, why wouldn't I hold and benefit from the tax savings?
There are five primary reasons why you would not exercise and hold:
1. You Don't Have Enough Cash to Exercise and Hold: Remember, a same-day exercise and sale gets you $10,000 in your pocket instantly (with a looming tax bill) and you don't have to "write a check" to acquire the shares. (Using the same figures from the example above). If you're going to exercise your right to purchase the shares and hold onto them, this requires you to pay $2,000 ($2 per share for 1,000 shares). For some people it can cost tens (or hundreds) of thousands of dollars to purchase those shares. Not everyone has that kind of cash laying around, so doing a simultaneous exercise/sale transaction may be their best and only choice. A potential AMT bill adds to the total cash need (see next point).
2. You Don't Want to Get Hit with AMT
In the example we’ve been using, there is a $10 purchase discount per share: you can buy something for $2, even though it is valued at $12 per share. This is sometimes referred to as the “discount” or “spread”.
Exercising ISOs when you are getting a discount doesn't create a “regular” tax bill until you decide to sell the shares. However, the "discount" is treated as income for the AMT (Alternative Minimum Tax) calculation. Most people are not subject to AMT to begin with, but they typically have a cumulative amount of ISO “discount” that they can take on before being hit with the AMT tax.
Example: Let's say you have $5,000 of “discount room” before AMT kicks in on your tax return. You would be able to exercise as many shares as possible until your total discount adds up to $5,000. Everything over $5,000 would likely create an AMT tax bill. Federal AMT tax rates are usually at 26% or 28%, plus potential additional state AMT.
Your tax or financial advisor should be able to provide you with how much "discount" room you have if you are thinking about exercising and holding ISOs.
Even if you have enough funds to pay for the ISO exercise, it may require much more to pay the corresponding AMT tax bill. Paying a few thousand to exercise may not be much, but paying tens of thousands in AMT may be a deal breaker. You may want to just exercise and sell, take the money, and keep it simple.
It is worth noting that AMT tax bills are most often a prepayment of tax of sorts. That additional tax is likely to come back to you in the form of a tax credit in the year you sell the underlying shares, assuming your tax preparer correctly reports the transaction. Also, if you exercise and sell within the same calendar year, there is usually no AMT tax on exercise. If you would like to learn more about AMT and the AMT Credit, we recommend this article.
3. You Don't Have a Deep Conviction About the Company
If you like the current price of your company stock from a selling perspective, and you feel it is overvalued or that it will decline in the future, then exercising and selling may make more sense. If you think the price is going to decline, then it would not make sense to hold onto your shares for a lower tax rate. A 10% tax discount won’t do much if the shares decline by 30%.
4. You Want to Invest Elsewhere and Diversify
Even if you do believe in the future of your company, you may not believe it is the best investment out of all the choices available to you. There are thousands of companies to potentially invest in, and you may not want to limit your investment exclusively or primarily to your company.
Additionally, you may want to spread out your risk to diversify your “bets” and protect against significant losses. There is a great saying: “Concentration can make you rich, but diversification keeps you rich.” Your company may be doing really well, but is it worth having something like 80% of your net worth tied to one company? From competition to accounting fraud to CEO scandals, there are many things that can go wrong with any specific organization. History is filled with “failed” companies that were once deemed invincible. Reducing your position from 80% of your net worth down to let’s say 25% doesn’t mean you don’t believe in the company's future success; it means that you’d like to spread out your risk a little bit.
5. You Have a Specific Goal to Fund
Even though you may want to hold on to your company’s stock with the hopes of paying a reduced tax rate on future sales, you may have a goal that is more pressing or would make you happier. Making the most money is not the point for most people, and it rarely is a top priority. For many, accomplishing specific goals is and should be the priority.
As an example today you could put a down payment on your dream home. Or you could keep the funds “at-risk” in your company’s stock with the hopes of saving tax dollars next year. Paying down debt, diversifying holdings, making tuition payments, purchasing vacation homes, enabling early retirement, and funding meaningful gifts are some of the common goals that make people lean towards selling shares right away instead of holding out for potentially higher after-tax proceeds.
Many times with “goals-based planning” the outcomes are binary: you bought the dream home or you did not. If you sell the stock today, you get the home. If the stock goes up over the next year, you still get the home (maybe with some nicer furniture). If the stock goes down, you may not get the home. Other examples are a tuition payment, a vacation home, and early retirement.
Doing Nothing - Holding on to Your Options
In order to exercise and hold, you need to believe in two things: that the value of stock will remain the same or rise, and that long term capital gains will be lower than the current ordinary tax rates. In order to exercise and sell, you need to want the cash and/or not be totally certain that future value will be higher. And what if neither is the case for you? Then perhaps holding on to unexercised options is the right call.
With the benefit of hindsight, we can always look back and kick ourselves for not exercising shares at a certain time, but the reality is that companies don’t always have amazing outcomes. When the Fair Market Value of shares are low, there might be a reason they are low - there wasn’t enough certainty of a bright future. It is perfectly acceptable to take a “wait and see” approach.
Generally, it is a good idea to discuss potentially exercising shares at least once per year.
In Summary
Most often than not the optimal ISOs scenario is a combination of all three: exercise and sell some, exercise and hold some, and wait out for future exercises for the rest. A detailed assessment of current and future cash needs, tax situations, and life events will enable you and your financial professional to design the plan that could work best in your particular case, both from dollar value and life satisfaction standpoints. As always, personal finance is very personal.
We hope that you found this helpful, and that your understanding of ISOs is better after reading this. If you have any additional questions around stock options, feel free to poke around the blog, send us an email, or schedule a time to chat.