Feb 22, 2023
Avoiding pitfalls with your incentive stock options
Understanding the nuances of incentive stock options (ISOs) can be challenging. They may feel like a winning lottery ticket when you receive them, but it’s important to understand how they work and the potential tax implications.
We see the decision on what to do as more of an art than a science. Things you may want to consider include time to expiration, stock price relative to grant price, how it fits into your overall plan, liquidity and other factors.
What are ISOs?
ISOs are a type of employee stock option that gives you the right to purchase shares at a set grant price determined by your company.1 The difference between the current stock price and the grant price is often called the spread.2
Regular (non-statutory) options are immediately subject to ordinary tax on the spread when exercised. ISOs, on the other hand, have preferred tax treatment.3
In theory, with ISOs you owe no tax at exercise. If you hold the shares for at least two years from the date they were granted and one year from the date you exercise the options, you only pay capital gains tax on the spread when you sell the stock. This can make a big difference when, according to the Internal Revenue Service website, the current maximum ordinary rate is 37%, versus only 20% for capital gains.4
The AMT trap
There is a potential tax trap, however. Exercising and holding ISO shares may trigger alternative minimum tax (AMT) in the year of exercise.5 Often times, people find out about this triggering of AMT after it’s too late to do anything.
Can you avoid this? If you sell ISO shares within the same calendar year that you exercise, you can wipe out AMT.6 This may or may not be the best strategy for your circumstances, but it’s worth considering if the stock price declines and you owe AMT. In an extreme case, it may help you avoid paying more tax than the stock is worth.
Therefore, it’s generally best to exercise ISOs early in the calendar year. This gives you the most time to watch the stock and see if selling before December 31 makes sense.
Private company considerations
If you work for a private company, selling the stock to avoid AMT may not be an option. You may also have to use your cash to exercise and hold ISO shares, versus selling a portion of the granted shares to cover the exercise cost. This could be disastrous if you lack the liquidity to cover both the exercising of the stock options and an unexpected AMT liability. Therefore, we believe that it’s important to run a tax projection before exercising ISOs.
Some other things to consider include the following:
- Once you use your money to exercise and buy these shares, you now have your “skin in the game.”
- What is your goal—to maximize wealth, lock in what you have now or somewhere in between?
- Do you have enough cash to cover the cost of exercise?
- Can you afford to lose the money if the stock becomes worthless?
- Is the company starting the initial public offering process?
- Do you plan to stay with the organization?
Our experience suggests that managing ISOs can be difficult for some, however, a well-constructed plan allows you to avoid pitfalls and capitalize on opportunities to build and protect your wealth.
1 https://www.investopedia.com/terms/i/iso.asp
2 https://www.investopedia.com/terms/s/spread.asp
3 https://www.investopedia.com/terms/i/iso.asp
4 https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2023
5 https://www.nceo.org/articles/stock-options-alternative-minimum-tax-amt
6 https://www.jpmorgan.com/wealth-management/wealth-partners/insights/incentive-stock-options-and-the-AMT
ABOUT THE AUTHOR
Gary Pattengale, CPA, CFP
Gary is a Wealth Manager at BDF and member of the Firm’s Investment Committee. He specializes in executive and stock-based compensation plans, including stock options, restricted stock and deferred compensation. He combines his tax knowledge, executive compensation experience and capital markets expertise to help clients reduce their tax burdens and achieve each of their unique goals.
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