Incentive stock options may be offered as part of an employee compensation package. In a best-case scenario, these options can offer an invaluable benefit to you as an employee. You may benefit most if your company offers incentive stock options (or ISOs) at a low exercise price, and then the company stock price increases substantially.
For example, let’s say that you receive 1,000 incentive stock options with an exercise price of $10 per share. If your company stock price increases to $250 per share, your options become incredibly valuable.
In this scenario, you can buy each share at $10 per your incentive stock option agreement and immediately sell that same share for $250. That’s a $240 per share profit. And remember, you have not just one share, but 1,000. Multiply your 1,000 options by $240, and you’ll see the total value of your incentive stock options is $240,000.
While the above scenario illustrates the seemingly simple math to determine the potential value of your incentive stock options, the truth is that levering your incentive stock options is not always a straightforward process.
The 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 the best strategy to use when deciding how to exercise and hold or exercise and sell your incentive stock options.
Other variables you might want to consider are things like the grant date of the incentive stock options, when you choose to exercise, how long you hold the shares for, and when the final sale of these shares occurs. Each of these details matters when determining which course of action to take – which is why dealing with incentive stock options is a complicated matter.
But don’t let that push you into paralysis. You may want to act on your incentive stock options. Let’s take a look at some hypothetical exercise strategies that you can use with your incentive stock options. Keep in mind that this is not an exhaustive list, and you should consider how your situation impacts what may be best for you.
Case 1 – Exercise Your Incentive Stock Options and Hold the Shares
The decision to exercise and hold could be the right one for many reasons. If you want to maximize the tax benefit of incentive stock options by meeting specific holding periods, you might start with this plan (especially considering you have to work with it to make Strategy 4, below, possible to use).
If you choose to exercise your shares and hold them, you will need to report the bargain element as a tax preference item for calculating the alternative minimum tax for the year you exercise and hold the shares. The bargain element is calculated as:
(Fair Market Value at Exercise – Exercise Price) * Options Exercised
Using the hypothetical example above of you and your 1,000 options with an exercise price of $10 per share and a fair market value at exercise price of $250 per share, the bargain element will be $240 per share ($250 minus $10 = $240 per share).
At $240 per share, you would have a total bargain element of $240,000.
As we discussed, the bargain element is an adjustment to the alternative minimum tax (AMT) on your 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. You’ll also want to plan for how you can manage the potential cash flow crunch associated with an exercise and hold of incentive stock options.
After exercising the option and holding the shares, you own them outright and are subject to the risk and reward associated with owning an individual stock position. If the stock price appreciates, the value of your shares will increase. If the stock price goes down, the value of your shares will decrease. You’ll want to be comfortable that you understand just how much money you are willing to put at risk before you move forward with this particular strategy.
Case 2 – Exercise Your Incentive Stock Options and Sell the Shares Immediately
If your objective is to diversify* your stock options as quickly as possible, an exercise and sell strategy might make the most sense. You can implement this plan as early as the options are vested, as late as the last day prior to expiration, or anywhere in between.
If you do exercise and sell your shares immediately, you will do so as a disqualifying disposition. A disqualifying disposition is an exercise and sell that does not meet the holding period requirements to obtain long term capital gains treatment. The result is that your bargain element will be taxed as ordinary income.
Ordinary income tax, however, might be a worthwhile tradeoff (as opposed to using a different strategy that leaves your profit taxed at a lower capital gains rate) because selling the stock on the same day as the exercise removes the risks associated with an exercise and hold in case 1.
If exercising and selling your 1,000 stock options results in a $240 profit per share, then your total gain of $240,000 will be taxed as ordinary income. Assuming a 32% tax bracket, this transaction would lead to a $76,800 tax liability.
That might seem like a big number — but remember that by selling immediately, you remove the potential investment risk and meet your goal of investment diversification*.
Case 3 – Sell Your Shares 1 Year After Exercise and 2 Years After Grant
A qualifying disposition of incentive stock options occurs when you sell your incentive stock options shares at least 1 year after exercising them and 2 years after they are granted. If the rules of a qualifying disposition are met, the difference between the exercise price and the final sales price is treated as a long-term capital gain.
One hope of meeting the holding requirements of incentive stock to get a qualifying disposition is that it allows you to capture long term capital gains on the realized gain on the transaction.
In the hypothetical example that we’ve used throughout this article, the cost basis (what you paid for the shares at exercise) of the shares of stock is $10,000 ($10 per share X 1,000 shares). The sales price is $250,000 ($250 per share X 1,000 shares).
(Note: This example assumes that the share price is the same on the date of exercise and the final sale date that occurs at least one year after exercise – and is purely for illustrative purposes only. The results of any investments are unpredictable.)
In the example, the gain of $240,000 is taxed at the 15% long-term capital gains tax rate. That makes your tax liability here $36,000 (15% X $240,000) — which is considerably less than the $79,2000 you would owe if you were taxed at ordinary income rates instead.
That might make case 3 look like the apparent winner — but keep in mind this requires you to hold the shares rather than selling them immediately. When you hold your shares for some time, you expose yourself to the risk-reward tradeoff associated with investing in a single stock.
In practice, the actual calculations for a qualifying disposition may be materially more complicated. When you exercise and hold your incentive stock options, the bargain element is a tax preference item for figuring the alternative minimum tax.
If you are subject to the alternative minimum tax, you may owe tax for the year you exercise and hold your incentive stock options, even if you don’t sell them. This tax may come back to you in the form of a tax credit when you sell your previously exercised shares.
Case 4 – Disqualifying Disposition of Incentive Stock Options – Anything other than a Qualified Disposition
A disqualifying disposition can occur intentionally (which is what happens in Strategy 2) or unintentionally (for someone who is seeking to make a qualified sale but, for one of many potential reasons, does not).
A disqualifying disposition of incentive stock options looks similar to an exercise of non-qualified stock options from a tax standpoint. The gain, generally speaking, is taxed as ordinary income. However, the gain from a disqualifying disposition of incentive is not subject to Medicare and Social Security tax.
There is any number of reasons you might sell early rather than wait out the period required to get a qualifying sale, but whatever your reasons, there will be some typical results — including tax ramifications.
An AMT adjustment (mentioned in case 1) could occur in the year of exercise and the year of sale. You may also need to report a short-term capital gain (or loss) on the difference between the exercise price and the sale price. The final tax impact will be driven by when you exercise when you sell, the timeline between events, the calendar year of the events, and what the proceeds are for each part of the transaction.
Whatever Your Strategy, Choose a Plan Wisely and Then Get in Action
Incentive stock options can provide you with the distinct advantage of being eligible for favorable long-term capital gains treatment if you exercise them appropriately. But pursuing any strategy that allows you to pay less in tax likely means taking on more investment risk, including the risk of holding potentially significant positions of concentrated equity.
As always, a plan to address the upside and downside of holding stock is key. Also, 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. The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment. Diversification does not guarantee a profit or protect against a loss. 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. Tax services are not offered through, or supervised by, The Lincoln Investment Companies.