Incentive Stock Options

8 Advantages of Incentive Stock Options You May Want to Know

Last Updated on April 22, 2020 by Daniel Zajac, CFP®, AIF®, CLU® Leave a Comment

Incentive stock options are a powerful compensation tool that can help you grow your wealth. Companies award them to employees as a retention vehicle, to reward specific successes or as an incentive when trying to attract new employees.

There are several advantages to incentive stock options. Because they can provide you with a significant opportunity, it’s important to understand them more fully.

The Mechanics of an Incentive Stock Option

To begin with, it’s helpful to understand more about incentive stock options, including how they work and how you can take advantage of their potential. An incentive stock option is a stock option that gives you the right to purchase shares of stock at a predetermined price. Unlike other forms of stock options, such as non-qualified stock options, incentive stock options can only be given to company employees.

When you are awarded incentive stock options, the company will provide you with an option grant, a document that specifies the number of shares you’re eligible to purchase and what’s called the “vesting schedule,” which dictates the dates the options are available to be sold. The incentive stock option grant will also include a share price, called the “exercise” price, which is typically based on the stock price on the day the company grants your options. The exercise price determines how much you will pay for each incentive stock option. This price, multiplied by the number of granted options will tell you how much it will cost you to exercise all your options.

Let’s look at several advantages to incentive stock options.

Advantage 1. Simple Process for Exercising

When you purchase shares through a stock option grant, the process is known as exercising your incentive stock options. Assuming the company stock price has risen since the time that you were awarded the stock option, you will have the potential benefit from that price appreciation. The process for exercising your incentive stock options is relatively straightforward, and you can exercise your options in one of several ways, depending on your short- and long-term financial goals.

Generally speaking, you can exercise your options once they have vested. Some plans, however, will offer an early exercise option that allows you to exercise before your shares are vested. If you do exercise your shares prior to the vesting, you are likely buying some that you cannot yet sell. The ability to sell the shares is subject to the vesting schedule.

When you exercise, you can typically do it in one of several ways. First, you can pay cash to purchase the shares. For example, let’s say you were granted 5000 options at an exercise price of $20 per share. One thousand shares have vested since you received your option grant. You could purchase those 1000 shares for $20,000 in cash. (1000 x $20 = $20,000.) By purchasing the shares upfront, you have the opportunity to hold them to take advantage of certain tax benefits, which we’ll discuss below regarding long-term capital gains. One risk associated with this approach is that your investment is subject to a possible downturn in the stock price. It may also reduce your ability to maintain a diversified portfolio by tying up your cash in the company’s stock.

Second, you can exercise your incentive stock options through what’s called a “cashless exercise” or “sell-to-cover” where you immediately sell some of your exercised shares, using the profits to pay for the option costs, and potential taxes, keeping the remainder, as discussed below.

The third approach is to exercise and sell all your shares immediately, commonly referred to as a same-day sale.

While the actual steps for exercising your incentive stock options are relatively simple, the method you choose depends on several factors, including when you need the income from the stock sale, possible tax strategies, and your confidence in the future growth of the company. A financial professional can advise you on a sound strategy and help you maximize your return based on your situation.

Advantage 2. You Choose When to Exercise Your Incentive Stock Options

Once your incentive stock options have vested, you have the flexibility to choose when to exercise your stock options. Some of the factors you’ll want to consider include how much the shares have appreciated in value since they were awarded, the likelihood of the company continuing to prosper, and whether you need cash in the near term. All these factors can impact when you decide to exercise your options. Note that there are also many factors outside of the company’s control that can affect the stock price, both positively and negatively, so this should be taken into consideration when deciding when to exercise your options.

There are two definitions associated with exercising incentive stock options, depending on how long you hold your shares before selling them after exercising your options. If you sell the resulting shares less two years from the grant date and less than one year from the time of exercise, the sale will be considered a “disqualifying disposition.” The benefits of a disqualifying disposition may include reducing the risk of volatility of the company stock by selling the shares sooner and receiving the proceeds more quickly. If you hold the exercised shares for more than one year before selling, they will be considered a “qualifying disposition” allowing you to take advantage of the lower, long-term capital gains tax treatment, saving you money at tax time.

There is an important exception regarding the timing of exercising incentive stock options. In your company role, if you have advance knowledge of company earnings results or other significant business information, you may be deemed an “insider” and restricted to selling stock during a specific trading window. This window typically opens immediately following earnings announcements and closes by mid-quarter. If you’re deemed an insider, the company will likely notify you in advance to help protect you from any inadvertent wrongdoing. Within the confines of the trading window, you are free to exercise your vested options at your discretion.

Advantage 3. Potential to Participate in Stock Price Appreciation

Ordinarily, purchasing company stock on the open market requires you to use your funds to acquire the stock. If the stock appreciates, your money is working for you. If the stock price declines, your investment is worth less than when you started. Incentive stock options give you the potential to participate in the appreciation of a stock with no capital outlay or financial risk on your part.

As an example, let’s say you were granted 1000 shares of company stock through an incentive stock option, priced at $15. Over five years, the 1000 options fully vested, and the stock price increased to $50. If you exercised your options and immediately sold your shares, your profit from the options would be $35,000, minus appropriate taxes and fees. In this scenario, you would receive a $35,000 profit with zero initial financial investment.

Incentive Stock Option Grant Cost – 1,000 shares @ $15/share = $15,000

Current Share Value – 1,000 shares @$50/share = $50,000

Potential Profit – $50,000 – $15,000 = $35,000

If you had purchased the same 1000 shares for $15 with your cash and held them for five years, your capital outlay would have been $15,000, rather than zero. You would still earn the $35,000 in gains from the share appreciation, and you may benefit from long-term capital gains tax treatment. However, in this scenario, you would need to come up with the initial investment, which would have been subject to potential market volatility, and your funds would have been tied up for five years to accomplish the same profit.

Cost to Exercise and Hold – 1,000 shares @ $15/share = ($15,000)

Current Share Value – 1,000 shares @$50/share = $50,000

Potential Profit – $50,000 – $15,000 = $35,000

As you can see, incentive stock options can be a powerful way to participate in stock price appreciation without having to put your own money at risk.

Advantage 4. Not subject to Payroll Taxes

Tax treatments are an important part of financial planning and a topic that requires careful consideration. One of the advantages of incentive stock options is the tax treatment they receive. As discussed, there are two approaches to exercising your options – qualifying and disqualifying dispositions. Qualifying dispositions are treated as long-term capital gains. Disqualifying dispositions are treated as ordinary income, with an important difference. There are no payroll taxes associated with the income from a disqualifying disposition, saving you a potentially significant amount of tax dollars.

Your earned income is not only subject to standard income tax, but also payroll taxes for Medicare and FICA. Medicare tax helps provide health insurance to retirees 65 and older, as well as some who are disabled. Medicare is taxed at a rate of 2.9% of your total wages, half of which are paid by your employer, and half of which (1.45%) you pay. Medicare taxes are applied to all earnings, regardless of your income level and an additional 0.9% tax for married couples filing jointly with incomes of $250,000 or higher or individuals earning $200,000 or more (in 2020).

FICA, the Federal Insurance Contributions Act, helps pay for Social Security. In 2020, the Social Security tax rate is 6.2%. The maximum Social Security tax employees and employers will each pay in 2020 is $8,537.40.

Because the profits or income from Incentive stock options are not subject to FICA or Medicare payroll taxes, you can keep a meaningful amount of the profits from your stock exercise.

Advantage 5. Opportunity to Obtain Long-term Capital Gains

There are times when you need to be able to access the profits from an incentive stock option quickly, perhaps to cover the cost of a down payment on a home, college costs, or other needs. However, if you have the flexibility to exercise and hold your shares for more than one year before selling them, the sale is considered a qualifying disposition, as discussed above.

One of the key benefits of qualifying dispositions is the tax treatment they receive. Qualifying dispositions are treated as long-term capital gains, which can lower your tax burden on the profit you’ve realized from the sale. This is attractive because long-term capital gains are typically a lower tax rate than ordinary income or short-term capital gains rates. In addition, many other compensation programs, such as non-qualified stock options, are treated as ordinary income on your W-2, creating a potentially significant tax burden. Incentive stock options are a type stock option type that may allow you to take advantage of long-term capital gains tax rates, making them an attractive component of your overall compensation.

Advantage 6. May Get Alternative Minimum Tax Back as AMT Credit

When you exercise your incentive stock options, you may be subject to the alternative minimum tax.

In the given tax year, when you exercise your incentive stock options, the difference between the exercise price of the options and the fair market price at exercise is considered income that can trigger an AMT liability. Fortunately, you may be able to take advantage of the AMT credit for the year you sell your incentive stock option shares as a qualifying disposition. The AMT credit may help to reduce your tax liability.

Because of the complexity of these tax issues, it’s often valuable to review your financial situation with a professional who can help you get the most out of the current tax programs and limit your tax liabilities.

Advantage 7. Participate in the Success of the Company

Typically, if you’ve received incentive stock options, it is a recognition that you are a key contributor to your company’s success. As the company prospers, the stock price often will rise, and the value of your options will increase along with it.

It’s not uncommon when working for a larger organization for there to be a feeling of distance between an individual’s work and the overall success of the company. Incentive stock options help to create a feeling of ownership, pride, and proximity to the company’s success. This feeling of ownership in the company, and the prospect of increased income, often improves employee retention, morale, and employee satisfaction. Your efforts to help the company succeed are rewarded tangibly through the value of incentive stock options.

Advantage 8: Managing Cash Flow Required to Cover the Cost of the Alternative Minimum Tax

As we discussed, exercising your incentive stock options may trigger an AMT liability, which can cause a cash flow shortage at tax time. A way to manage this issue is to focus on your cash flow by exercising your options and strategically holding the shares, selling them when cash is needed to pay the additional AMT costs. This approach is called AMT balancing.

AMT balancing may help insulate you from having to come up with a large amount of cash to pay your tax bill but also allows you to spread out the sale of your stock shares. There are a few reasons why this approach might be advantageous. For example, it can enable you to hold onto a portion of the shares beyond a 12-month window so that the profits on the shares will be treated as a qualifying disposition. This approach may allow you to manage the costs of the AMT liability while maximizing the long-term growth of the company’s stock.

As you can see, there are several important strategic decisions to make to maximize your incentive stock option profits. An investment professional can help you map out your strategy to take full advantage of this powerful compensation vehicle.

The content herein is for illustrative purposes only and does not attempt to predict the 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 situation. Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

Tax Rates on Qualifying Dispositions of Incentive Stock Options May Offer a Tax Buffer – But Watch Out for Investment Risk

Last Updated on April 10, 2020 by Daniel Zajac, CFP®, AIF®, CLU® Leave a Comment

If you have stock options, then you can access an asset that provides you with a choice. Very literally, a stock option is an option; it’s a form of compensation that gives you the right (but not the obligation) to buy shares of company stock at a set price.

Acting on this choice is known as exercising your stock options. To decide whether or not you want to exercise your options, you might want to look at the current stock price.

If the current stock price is below the price at which you can exercise, your option is underwater or “out-of-the-money.” There may not be much point in exercising here. If the fair market value of the share is higher than the price at which you could exercise, however, the option is “in-the-money” and it may make sense to exercise.

But before you do, you may want to understand that exercising your options is a taxable event.

When exercised, the spread between the exercise price of the option and the share’s fair market value is one of the significant factors that determine your tax liability. Still, it’s far from the only thing you need to consider.

Another key factor is what kind of option you have: incentive stock options or non-qualified stock options. From there, you may have to think through holding periods, the alternative minimum tax, how handling your options impacts your cash flow, your investment risk tolerance, what your end goals are, and so on.

Understanding precisely what you’ll owe come tax time is never straightforward, and stock options only further complicate the picture. So let’s take a deep dive into this issue today and specifically look at incentive stock options.

Here’s what you need to understand if you want to build a sound strategy to manage and make the most of your incentive stock options.

What Is an Incentive Stock Option?

An incentive stock option is a particular type of employee compensation that can only be offered to a company’s employees up to certain amounts (as opposed to non-qualified stock options, which can be awarded to employees, consultants, advisors, and other non-employees).

You might hear these referred to as statutory stock options, as well. Either way, incentive stock options, or ISOs, can be a highly desirable form of equity comp for many reasons — including the fact that they may be taxed at lower rates than other types of options or grants of company shares.

Lower tax rates mean that you may be able to pay long-term capital gains tax rates on realized gains from the original exercise price to the final sales price. Long term capital gains tax rates are attractive because they are usually lower than short-term capital gains rates and ordinary income rates.

But to obtain this preferential tax treatment, you’ll need to achieve a qualifying disposition for your incentive stock options.

A qualifying disposition requires that you meet two special holding period rules. They are as follows:

The final sale of the stock must occur at least 2 years from the grant date of the stock option, AND
The final sale of the stock must occur at least 1 year from the exercise date of the stock.

Anything that does not meet these rules is known as a disqualifying disposition, and won’t qualify for long term capital gains. Instead, realized gain from a disqualifying disposition will often be taxed as ordinary income and short-term capital gains.

While the idea of paying long-term capital gains tax rates (as compared to ordinary income) looks appealing, managing your incentive stock options isn’t always that straightforward. When you exercise and hold your shares to meet the 1-year hold requirement, you also need to look at the impact of paying the alternative minimum tax.

The Alternative Minimum Tax on Incentive Stock Options

The alternative minimum tax, or AMT, may be applied to the spread between the exercise price of an incentive stock option and the share’s fair market value at exercise. This spread is known as the bargain element. AMT acts a bit like prepayment of the tax due on the final proceeds of your incentive stock options.

AMT is based on a parallel tax system to the regular federal income tax system. This means you need to calculate your income tax twice every year: once under the regular tax rules, and a second time under the rules that apply to AMT. After you run the numbers and compare them, your tax due is the higher of the two.

To calculate AMT, you first need to calculate your Alternative Minimum Taxable Income (AMTI). AMTI adds back certain deductions and adjustments into your taxable income, and many of deductions you might enjoy on regular federal taxes do not apply here.

AMTI also includes the bargain element (which is the difference between the exercise price of your stock option and fair market value at exercise, multiplied by the number of shares purchased) of exercising your incentive stock options as income.

For comparison, the bargain element is not counted when figuring your regular income if you exercise and hold the shares. The result of its inclusion in AMTI means exercising ISOs may inflate your AMT in the year you exercise your incentive stock options.

Once your AMTI is calculated, then the exemption is applied to find your Alternative Minimum Tax Base:

Alternative Minimum Tax Base = Alternative Minimum Tax Income – Exemption

AMTI is taxed at a flat 26 and 28%. If your AMTI is below the 26%/28% dividing line, you’ll be taxed at a flat 26% rate. If AMTI is over the dividing line, then the portion of your income below the dividing line is taxed at 26% and the remainder is taxed at 28%.

This leads to the tentative minimum tax (TMT). If your tentative minimum tax is below your regular tax, you will not owe AMT. If your tentative minimum tax is higher than the regular tax, you will owe AMT. The AMT you actually pay is the difference between your regular tax and your tentative minimum tax when the tentative minimum tax is the higher of the two.

The Impact of AMT on Qualifying Dispositions Versus Disqualifying Dispositions

If you have ISOs, you may or may not be subject to the AMT. Incentive stock options are taxed differently based on whether or not you do a qualifying or disqualifying disposition, as well as the timing of your transactions.

As a result, you may incur the following types of taxes after you exercise your options:

Compensation Income: Taxed as ordinary income
Capital Gains: Subject to short-term and long-term capital gains rates
Net Investment Income Tax (NIIT): A supplemental tax of 3.8% on capital gain assets in excess of certain amounts
Alternative Minimum Tax (AMT): Subject to a second set of tax calculations, typically taxed at 26% or 28%

If you do a disqualifying disposition of your incentive stock options, the realized gain between the exercise price of the stock option and the fair market value at exercise is generally taxed as compensation income (not subject to payroll tax, nor is income tax withheld).

If the final sale of the stock occurs in the same calendar year of the exercise, you will not be subject to AMT. If the final sale occurs in the year following the year of exercise, you will need to report the bargain element as a tax preference item for the calendar year you exercised and held.

This means that even with a disqualifying disposition, you may be subject to AMT. It all depends on the timing of your transactions.

If you do a qualifying disposition, on the other hand, the bargain element is a tax preference item when figuring the AMT for the calendar year you exercise. You’re then subject to the corresponding AMT taxes that may be triggered by this.

When you sell your incentive stock option shares in a final sale, you pay long-term capital gains rates on the realized gains from the original exercise price to the final sales price.

If you follow the above scenario, you might think it looks like you paid taxes on the bargain element portion of the transaction twice: the first time via the AMT in the year you exercised and held, and the second when you sold your shares in a final sale as long-term capital gain.

So we need to talk about the AMT credit.

How the AMT Credit Impacts Your Incentive Stock Options

When you sell your ISO shares in a final sale, the AMT credit may allow you to recover some or all of the prepayment of AMT.

The credit is partially figured by a tax calculation that refigures your capital gains using a dual basis: one basis for capital gains shares for your regular tax rate, and one basis for those same shares for your tentative minimum tax.

Generally speaking, the spread between your regular capital gains and your capital gains as refigured for AMT may be used as a negative adjustment when figuring your AMTI. A negative adjustment to your AMTI may lead to a lower alternative minimum tax base and a lower tentative minimum tax.

If you’ve previously paid AMT due to incentive stock options, and have a tentative minimum tax that is lower than your regular tax, the difference the two may be eligible to come back to you as an AMT credit.

And if you previously paid AMT from incentive stock options you exercised that weren’t eligible for the credit in one year, you can carry that forward to potentially use in future years. Carryforward AMT credit is common, as the AMT credit may not fully be refunded in the calendar year following the year you sell the stock (when you file your tax return).

The Timing of When You Pay Taxes Due and Other Cash Flow Considerations

In addition to understanding what type of tax you may owe depending on whether you have a qualifying or disqualifying disposition, you should consider when you’ll owe those taxes.

Generally, taxes are due on the normal tax date of April 15 (or the specific date for that calendar year if the 15th falls on a weekend or holiday). This will happen in the year following the year of your transaction if taxes owed are compensation income due to a disqualifying disposition or AMT due to an exercise and hold.

Similarly, when you sell your shares in a final sale, long-term capital gains, net investment income tax (NIIT), and AMT credits are not due (or credited) until April 15 in the following year. And while you might not need to pay your tax bill until April 15 of the following calendar year, you may need to make estimated tax payments in the year of the transaction.

This may be an option if you want to do some cash flow planning, or it might be required due to the IRS’ penalties for under-withholding. This is true regardless of when you exercise or sell your options/shares during the calendar year.

Your cash flow can be impacted by taxes owed as well as the exercise and sale of shares themselves. For example, when you exercise and hold your stock options, you may need to pay cash to cover the cost of the exercise.

When you sell your shares, you will receive the cash proceeds and should plan to manage that cash properly. Generally speaking, you may be able to time these cash flows to occur any time during the calendar year, from January 1 to December 31.

The chart below can help illustrate the timing of when your cash flow might feel the effects of your decisions with ISOs; the red text represents a negative cash flow event:

	Qualifying Disposition	Disqualifying Disposition
Cost of Shares	Due at the time of exercise	Due at the time of exercise, unless sold via a cashless exercise
AMT	Due by April 15 in the year following the year of exercise and hold	Due by April 15 in the year following the year of exercise (if you exercise and hold past the calendar year end)
Compensation Income Tax	N/A	Due by April 15 in the year following the year of exercise and sell
Long-Term Capital Gains Tax (or possibly Short-Term for Disqualifying)	Due by April 15 in the year following the year the final sale	Due by April 15 in the year following the year the final sale
Net Investment Income Tax (NIIT)	Due by April 15 in the year following the year the final sale	Due by April 15 in the year following the year the final sale
Sale Proceeds	Received in full in the year of final sale	Received in full in the year of final sale
AMT Credit	Credited in the year following the year of final sale, or carried-forward	N/A

Running the Numbers: Scenarios to Compare Disposition Types for Your ISOs

Many people feel tempted to make achieving a qualifying disposition, the primary objective of their stock option management strategy. But the possible value created by receiving a long-term capital gains tax treatment may not always be your best bet when you run the numbers.

The best course of action is likely subject to your gross income, the bargain element, and the type of disposition that is best for your entire financial situation. These factors impact how much you will pay in various taxes, how much you receive in after-tax proceeds, and when you get those funds.

That doesn’t even touch on what might be the most important factor in your entire decision-making process: the potential volatility of the stock during the one-year holding period requirement for a qualifying disposition, and how that investment risk could affect your overall financial plan.

We can look at a few different scenarios to see how this plays out with real numbers.

Qualifying Dispositions May Look Appealing From a Tax Viewpoint

We’ll start with a simple cash flow analysis that uses some underlying assumptions. Let’s say we have a hypothetical 50-year-old couple, making $250,000 per year, married filing jointly, using a standard deduction, with the following ISO grant:

Grant Date: January 1, 2020
Exercise Price: $1.00
ISO Shares: 10,000
Current FMV: $26.00
Final Sale Price: $26.00

We’ll also use the following tax rates:

Long-Term Capital Gains: 15%
Ordinary Income Tax: 24%
Alternative Minimum Tax: 26%

With our assumptions in place, we want to look at the outcomes of two scenarios. One will show a qualifying disposition where the couple exercises and sells their shares from their incentive stock options as soon as possible to qualify. The other shows a disqualifying disposition, where they exercise and sell ISO shares as soon as possible.

With this information, we can calculate the expected costs and expected proceeds for individual parts of the transaction. These calculations can then be used to model projected cash flows and profitability of a qualifying and a disqualifying disposition.

They include and are calculated as:

Negative Cash Flows:
- Cost of the Shares = ISO Shares Exercised x Exercise Price
- AMT = AMT Tax Rate x Bargain Element
  - Bargain Element = FMV at Exercise – Exercise Price
- Long Term Capital Gains Tax = LTCG Rate x (Final Sale Price – Exercise Price)
- Net Investment Income Tax = 3.8% x Long-Term Capital Gain
- Compensation Income Tax = Ordinary Income Tax Rate x Bargain Element
Positive Cash Flows:
- Final Sale Proceeds = Final Sale Price x ISO Shares
- AMT Credit = AMT Tax Rate x Bargain Element

We can illustrate the cash flows in a simple chart that compares the after-tax proceeds of a qualifying disposition and disqualifying disposition:

In this example, we could reasonably suggest that a qualifying disposition is the preferred outcome, as the “total value” is $13,000, or approximately 6.8% higher than the disqualifying disposition alternative.

Digging further into the details, we should identify several important notes with regards to the analysis:

The AMT credit is unique in that only a portion of an AMT credit may be refunded in the year you sell your ISO shares as qualifying disposition. The remainder will be carried forward to a future year. For our illustration, we have assumed 70% will be refunded, and 30% will be carried forward. It goes without saying that a personal tax projection should be considered to see how your return will be impacted.
On the qualifying disposition side of the ledger, we have included NIIT. NIIT is an additional tax of 3.8% that you may incur on realized capital gain assets when your income exceeds certain levels. In our example, it increases the tax rate on long-term capital gains from 15% to 18.8%. The net result of an additional 3.8% on capital gains is a reduction in the potential tax spread that you may gain between ordinary income and long-term capital gains rates, and a reduction of the perceived benefit of a qualifying disposition.

How Income Levels Impact Tax of a Qualifying and Disqualifying Disposition

Unfortunately, the simple example above does not fairly represent the nuance of incentive stock options. To get a more accurate understanding, we should test the above illustration using the actual 2020 tax law and several different income levels.

You’ll see that at different income levels, the amount you pay in ordinary income tax, AMT, and NIIT changes. Your income level may also impact how quickly you receive the AMT credit.

Let’s look at a few different levels to see this in action. We’ll use gross incomes of $50,000 (as our “low income” example), $250,000 (for a “middle” income), and $500,000 (to represent a “high” income).

Following our charts from above and figuring actual tax calculations, we see the following:

A few interesting points of note from the charts:

Long-term capital gains tax for each transaction are materially different. This is a function of the 0%, 15% and 20% tax brackets for long term capital gains. In the low-income scenario, some of the gains is taxed at 0% and the remainder at 15%. In the middle-income scenario, the full amount is taxed at 15%. In the highest income example, most of the LTCG is taxed as 20%, with a small portion at 15%.
This example shows that you will pay more in AMT in the middle-income scenario than you will in the high-income scenario. This is a result of how the regular tax and tentative minimum tax are calculated. In this middle-income range, the percentage spread between the effective regular tax rate and the effective tentative minimum tax is smaller than the spread between the two in the low- and high-income scenarios. A smaller spread in the average tax rates means a greater likelihood of AMT.
In the low-income scenario and the middle-income scenario, only a portion of the AMT is returned as a credit in the year of sale. For the low-income scenario, this is partially a result of a 0% LTCG rate. In the middle-income scenario, this is a result of the smaller percentage spread between the average regular tax rate and the average tentative minimum tax rate.
As your gross income increases, so do the likelihood of paying additional NIIT on your LTCGs.

To confirm the potential benefit of a qualifying disposition, we can compare the after-tax proceeds and total value at each income level. Using percentages to quantify the benefit of a qualifying disposition, we see the following:

We can also quantify by comparing cash values:

This provides us with a few more takeaways:

When the total value scenarios are reviewed, the low-income group benefits the least from a qualifying disposition, and the high-income group benefits the most. This suggests that a qualifying disposition may be most attractive to higher-income earners. This benefit is driven by a spread between the ordinary income tax rate and the long-term capital gain tax rate that is larger in the high-income tax brackets than the spread in the middle- and low-income tax bracket. A larger spread means a greater potential tax benefit of a qualifying disposition.
The after-tax value created by a qualifying disposition for low- and middle-income levels, as a percentage of the total value, is low. In the short term, there is less benefit to this strategy than there is in the long term. The potential longer-term benefit is tied to your receipt of the AMT carryforward credit.
In the high-income example, the after-tax proceeds and the total value are identical. This means that the full value of the qualifying disposition is received the ISO shares are sold, as the full AMT credit is refunded in the year following the sale (in this example – it’s possible that this may not always be the case in the high-income scenario). As it relates to cash flow, the financial benefit of a qualifying disposition may be more significant for a high-income earner as compared to a low-income earner.

Do Qualifying Dispositions Expose You to More Investment Risk?

The tax benefit of a qualifying disposition can be an attractive driver in planning a strategy for your incentive stock options. But to capture this tax alpha, you’ll need to hold the stock for at least one-year post-exercise.

That means taking on concentration risk, and in all likelihood, seeing the stock price fluctuate during this period.

An appreciating stock price likely means a higher sale price and a higher after-tax value. But a falling stock price might lead to a lower sales price and an after-tax value below any perceived tax benefit that you were seeking to obtain, leaving you wishing you had simply sold the stock as soon as possible.

To illustrate potential stock volatility and investment risk of a qualifying disposition, we can use a single stock to illustrate future stock prices. Below, we’ll use hypothetical stock “X” as our proxy.

Let us assume that hypothetical stock “X” had an average rate of return of 10.78% and a standard deviation of 19.54. If we apply the mean rate of return and standard deviation to our arbitrary $26.00 per share price, we can calculate what the future one-year price target as one, two, and three standard deviations may be:

With a projected stock price in place, we can update the incentive stock options cash flow charts and calculate the future values. We will use the middle-income scenario, with average tax rates equal to the calculated average tax rates in our middle-income scenario above.

Assuming a qualifying disposition, we see the following:

Qualifying Disposition – “X”	$13.56	$18.64	$23.72	$26.00	$33.88	$38.96	$44.04
Cost of Shares	($10,000)	($10,000)	($10,000)	($10,000)	($10,000)	($10,000)	($10,000)
AMT	($62,083)	($62,083)	($62,083)	($62,083)	($62,083)	($62,083)	($62,083)
Proceeds from Sale	$135,616	$186,420	$237,224	$260,000	$338,832	$389,636	$440,440
Actual LTCG Tax	($18,842)	($26,463)	($34,084)	($37,500)	($49,325)	($56,945)	($64,566)
NIIT	($4,773)	($6,704)	($8,635)	($9,500)	($12,496)	($14,426)	($16,357)
AMT Credit (First) Year	$44,035	$44,035	$44,035	$44,035	$44,035	$44,035	$44,035
After-Tax Proceeds	$83,953	$125,206	$166,459	$184,952	$248,964	$290,217	$331,470
AMT Carry Forward	$18,047	$18,047	$18,047	$18,048	$18,047	$18,047	$18,047
After-Tax Value	$102,000	$143,253	$184,506	$203,000	$267,012	$308,264	$349,517
Percentage Change	-49.75%	-29.43%	-9.11%	0.00	31.53%	51.85%	74.18%

There is significant dispersion in the after-tax value range of outcomes. To capture the tax alpha of a qualifying disposition, then, you’d have to accept the possibility of a 49.75% reduction in your after-tax value. On the positive side, you see a potential after-tax value increase of 74.18%.

To help decide if this risk/reward for capturing tax alpha is “worth it,” it makes sense to compare a qualifying disposition to that of a disqualifying disposition.

Let’s assume you exercise and sell shares immediately for a disqualifying disposition. You then take the proceeds and reinvest them into the same “X” stock. (Yes, this is an unlikely move in reality — but it will help illustrate what we want to investigate, which is the tax impact of the disposition types.)

With the identical future projected stock projections, we can illustrate the future after-tax values using a cash flow chart. Since we are assuming a disqualifying disposition, the tax implications change, and the chart should be updated accordingly.

Specifically, we’ll update the following:

If you exercise and sell on the same day (as we will use for our assumption), you will pay ordinary income tax rates on the bargain element.
The full value of the proceeds of the exercise and sell will be invested. Any future gain/loss will be subject to long-term capital gains (loss) and NIIT rates. For simplicity, we have valued the capital loss a positive offset at long-term capital gains rates.

Disqualifying Disposition	$13.56	$18.64	$23.72	$26.00	$33.88	$38.96	$44.04
Cost of Shares	($10,000)	($10,000)	($10,000)	($10,000)	($10,000)	($10,000)	($10,000)
Proceeds from Sale	$135,616	$186,420	$237,224	$260,000	$338,832	$389,636	$440,440
Gain/Loss	($124,384)	($73,580)	($22,776)	$0	$78,832	$129,636	$180,440
Long-Term Capital Gains	$0	$0	$0	$0	($11,825)	($19,445)	($27,066)
Net Investment Income Tax	$0	$0	$0	$0	($2,996)	($4,926)	($6,857)
Compensation Income	($73,703)	($73,703)	($73,703)	($73,703)	($73,703)	($73,703)	($73,703)
Value of Capital Loss	$23,384	$13,833	$4,282	$0	$0	$0	$0
After-Tax Value	$75,298	$116,551	$157,803	$176,297	$240,309	$281,562	$322,815
Percentage Change	-57.29%	-33.89%	-10.49%	0.00%	36.31%	59.71%	83.11%

The dispersion in the after-tax values is similar to the qualifying disposition scenario, as you would expect using the same rate of return and standard deviation assumptions. What might not be as obvious is a comparison of the after-tax values:

	$13.56	$18.64	$23.72	$26.00	$33.88	$38.96	$44.04
Qualifying Disposition	$102,000	$143,253	$184,506	$203,000	$267,012	$308,264	$349,517
Disqualifying Disposition	$75,298	$116,551	$157,803	$176,297	$240,309	$281,562	$322,815
Dollar Difference	$26,703	$26,703	$26,703	$26,703	$26,703	$26,703	$26,703

The after-tax value of the qualifying disposition is higher at every sample standard deviation than that of the disqualifying disposition. The largest tax benefit as a percentage of value is realized at the 3-standard deviation down market scenario.

A more substantial after-tax value across the table might help make an argument that all else being equal, a qualifying disposition is preferred to a disqualifying disposition in any market with the same performance metrics. This tax buffer provided in the down-market scenarios is a function of how both disposition types are taxed for ordinary income tax rates and long-term capital gain tax rates.

In a disqualifying disposition that occurs via an exercise and immediate sell, ordinary income is “locked-in” on the spread between the exercise price and the fair market value at exercise. If the market drops after the exercise and sell, capital losses may be used to offset future capital gains and/or ordinary income.

For our purposes and this illustration, we have assumed the capital loss will be used to offset future long-term capital gains.

In the qualifying scenario, long term capital gains are reported on the spread between the exercise price of the ISO and the final sale price (assuming it is the higher of the two). If you sell your ISO shares at a final sales price that is lower than the price as which you exercised, you will pay capital gains on the spread between the exercise price and the final sales price.

Previously paid AMT may be refunded against other ordinary income if your regular tax return calculations allow for it. In our example, we show this refund, which leads to the tax buffer.

In the example, we can also see that $26,703 — the spread in each scenario — is equal to the simplified chart above. If we were to calculate the models for low and high incomes (which wasn’t illustrated here), the results also equal the spread in the charts above.

This continues to suggest that the low-income scenario benefits the least, and the high-income benefits the most from a qualifying disposition of incentive stock options. This is a result of the spread between the effective regular tax rates and the effective tentative minimum tax rates.

Comparing Investment in a Single Stock to Investing Proceeds from Disqualifying Dispositions in a Diversified Portfolio

Again, it’s unlikely that if you secure a disqualifying disposition of ISOs that you would turn around and reinvest the proceeds into the same stock. You would most likely consider reinvestment into a diversified portfolio.

Adding an alternative allocation to the conversation, let’s assume that you reinvest the proceeds of a disqualifying disposition into a more diversified allocation, “Y” with the following metrics

Mean Return: 6.12%
Standard Deviation: 14.53%

Assuming the current market price of $26.00 per share, a one-year price target for the “Y” may be:

Following the same logic as above, we see the following:

Disqualifying Disposition – “Y”	$16.26	$20.04	$23.81	$26.00	$31.37	$35.15	$38.92
Cost of Shares	($10,000)	($10,000)	($10,000)	($10,000)	($10,000)	($10,000)	($10,000)
Proceeds from Sale	$162,578	$200,356	$238,134	$260,000	$313,690	$351,468	$389,246
Gain/Loss	($97,422)	($59,644)	($21,866)	$0	$53,690	$91,468	$129,246
Long-Term Capital Gains	$0	$0	$0	$0	($8,054)	($13,720)	($19,387)
Net Investment Income Tax	$0	$0	$0	$0	($2,040)	($3,476)	($4,911)
Compensation Income	($73,703)	($73,703)	($73,703)	($73,703)	($73,703)	($73,703)	($73,703)
Value of Capital Loss	$18,315	$11,213	$4,111	$0	$0	$0	$0
After-Tax Value	$97,191	$127,867	$158,542	$176,297	$219,894	$250,570	$281,245
Percentage Change	-57.29%	-33.89%	-10.49%	0.00%	36.31%	59.71%	83.11%

As expected, the dispersion of the more diversified “Y” as compared the “X” scenarios above is smaller. What might be more interesting, and unexpected, is the comparison of the after-tax values of a qualifying disposition of “X” vs. the disqualifying disposition “Y”.

Qualifying Disposition – X	$102,000	$143,253	$184,506	$203,000	$267,012	$308,264	$349,517
Disqualifying Disposition – Y	$97,191	$127,867	$158,542	$176,297	$219,894	$250,570	$281,245
Dollar Difference	$4,809	$15,386	$25,964	$26,703	$47,118	$57,695	$68,272

You’ll see that the after-tax value of the qualifying disposition of “X” is actually higher than a disqualifying disposition that is reinvested into a more diversified “Y.”

Couple this with the upside potential of the qualifying disposition, and you can argue that that tax buffer offered by a qualifying disposition of incentive stock options might create an opportunity to generate meaningful excess wealth with similar downside risk.

Single Stock Risk/Return May Drive Your Final Value More Than Your Tax Rate

While modeling potential tax implications can be an interesting exercise to value the tax advantage of a qualifying disposition, it goes without saying that you should evaluate your financial circumstances before implementing any ISO strategy.

While tax modeling may appear attractive on paper, it can quickly be wiped away if you have a single stock that under-performs whatever alternative investment you may choose. So you need to consider: How much risk are you willing to take? And how much company stock do you want to own?

The generally accepted consensus is that a single stock is more volatile than a basket of stocks. Therefore, it’s reasonable to assume that your stock may or may not perform as you hope (or plan for).

The risk that your stock might not perform as you hoped should be addressed in building your financial plan and overall investment strategy. If concentration risk is more than you are comfortable with, or if your concentrated equity position is too high, a disqualifying disposition may be something to consider regardless of the tax outcome.

Other Items That Can Impact the Cash Flow Analysis

The illustration above is one example of what may happen when considering your cash flows for a qualifying and disqualifying disposition. Many other scenarios can impact the analysis.

Some of these include:

The cost of the shares themselves: The higher the cost of exercise, the more money that you will need to buy the shares. This may make a disqualifying disposition more attractive if you are hesitant to absorb negative cash flows required to do an exercise and hold.

A higher cost of exercise may also lead to assuming the additional risk of loss. The more money you have in the transaction, the more you can lose if the stock price goes down.

The size of the bargain element: All else being equal, a higher bargain element means paying more in AMT. More AMT means more cash to exercise and hold, leaving less money available for other needs.

A significant bargain element may also lead to a more significant amount of carryforward AMT credit, and impact how fast you get it back.

The amount of time from your exercise of the ISOs to the final sale: Our example illustrated a scenario in which a qualifying disposition occurs as soon as possible or one year after exercise. If you extend the holding period, the value of a portfolio that has positive cash flows in the early years may be more beneficial if you consider the time value of money.

In other words, a dollar today is worth more than a dollar tomorrow. The further you push the sale of the stock into the future, the greater the value of positive cash flow from a disqualifying disposition in year one.

The expected rate of return of your single stock and the alternative investment: The closer the average rate of return and standard deviation of the two investment options, the closer the total values and the greater argument to seek a qualifying disposition.

Additional Planning Ideas for A Qualifying Disposition of Incentive Stock Options

Qualifying dispositions not only have potential tax benefits, but certain planning strategies may be available to consider with your ISOs once you exercise them.

1 – Exercise Early in the Calendar Year (to Allow for Year-End Planning)

A significant AMT bill may have a material impact on whether or not a qualifying disposition is a good or bad idea. The larger the AMT, the greater the negative cash flow required to exercise and hold.

A significant AMT bill may also result in a more substantial position in one company stock as a percentage of your net worth, as you may need to transfer non-company stock assets into company stock assets. One strategy to manage AMT risk is to exercise early in the calendar year.

Doing so may allow you to sell those same shares early in the following calendar year as a qualifying disposition. Once sold, the proceeds from that transaction may be available to cover the AMT bill itself.

If you wait until after the tax filing deadline to initiate an exercise and hold, you won’t be able to sell those shares as a qualifying disposition in time to use the proceeds for payment of tax due.

Exercising early in the calendar year also allows you to undo an exercise and hold that is currently subject to AMT. You can intentionally do a disqualifying disposition not subject to AMT.

This may be a good idea if your projected AMT is so large that it exceeds the value of the shares themselves (as it could be if the post-exercise value of the stock goes down). To avoid or minimize AMT in this scenario, it may be a good strategy to sell some or all of your previously exercised ISO shares before calendar year-end.

The sale will remove the AMT preference item, and you would likely claim the gain as compensation income, subject to ordinary income tax rates. The tax due can be paid with the proceeds of the disqualifying sale itself.

2 – Exercise Up to the AMT Crossover Point (to Reduce a Liquidity Squeeze)

Another way to manage AMT is to exercise and hold just enough shares that your tentative minimum tax equals your regular income tax. If done correctly, you will be able to exercise and hold some of your ISO shares, begin the holding period, and pay no AMT.

This amount of room you have to exercise will be based on your income level and filing status, among other factors. Generally speaking, there is more room in the low- and high-income space, and less room in the middle-income space.

The number of shares that you will be able to exercise will be subject to the spread between the exercise price and the fair market value of the stock and the spread between the tentative minimum tax and the regular tax.

If the larger the spread between the exercise price and fair market value of the stock, the fewer shares you will be able to exercise. The larger the spread between the tentative minimum and regular tax, the greater number of shares you can exercise.

You will want to balance these factors when you implement a strategy.

3 – Exercise When the Spread is Low and/or the Exercise Price is Low (or You are Bullish on the Stock)

It’s not uncommon to be excited about the prospects of your company stock and feel as though the stock price will go up in value. If you find yourself optimistic about your shares and are willing to assume the risk associated with a single stock, you may want to exercise and hold for a qualifying disposition.

By doing so (and assuming you are correct that the stock price goes up), two key factors work in your favor.

First, you likely pay less in AMT than you would have had you wait until the price was higher to exercise. A smaller bargain element, all else being equal, will mean a smaller AMT owed and potentially a greater opportunity to capture long-term capital gains on the stock appreciation.

Second, you begin the holding period necessary to meet the requirements for a qualifying disposition. This ability to sell shares sooner may be particularly relevant if you are looking to combine a qualifying disposition with a life event such as retirement or a target exit price of the stock.

If both the price and the spread are low, it may be time to consider an 83(b) election of your ISOs. This strategy may allow you to exercise unvested ISOs, pay AMT on the bargain element (which may be minimal), and begin the holding period for a qualifying disposition.

This strategy, however, comes with additional risk. Essentially, you must pay for something you may not currently own. If you leave your company or the shares go unvested, you will lose your money in the deal. Talk with an advisor with experience in working with 83(b) elections to help determine if this makes sense for your situation.

What This Means for Financial Planning and Incentive Stock Options

Incentive stock options can be a valuable tool for generating additional wealth. However, to fully take advantage of the potential benefits of an incentive stock option, you’ll likely want to consider many, many factors.

These include — but certainly are not limited to — looking at what your tax benefit may be and if that perceived benefit is worth the risk of owning a single stock for a required period.

The answer to whether or not you may be comfortable with increasing your concentration risk and holding a single stock to obtain a tax benefit, you might want to take a look at other financial planning questions. Consider asking yourself:

How close are you to retirement?
How much of your net worth is allocated to a single stock position?
What are your short- and long-term employment expectations with the company?
Are there mandated restrictions on retaining and/or selling your stock?
What are your expectations for future compensation?
What’s your outlook on the company and its potential?

As you answer these questions and dig further into tax analyses to determine what outcomes might be best, you may be able to begin developing a financial plan that integrates a strategy for managing your incentive stock options with an overall plan of action across all areas of your financial life so that everything works in tandem to help you achieve your goals.

The material presented is provided for informational purposes only. There is no guarantee that any strategies discussed will result in a positive outcome. You should discuss any legal, tax or financial matters with the appropriate professional. All investing involves risk and no strategy can guarantee a profit or protect against loss, including the potential loss of principal. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. Projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results and are not guarantees of future results. Diversification does not guarantee a profit or protect against a loss. Standard deviation is a statistical measure of the range of performance in which the total returns of an investment will fall. When an investment has a high standard deviation, the range of performance is very wide, indicating that there is a greater potential for volatility. “Mean returns are calculated by adding the product of all possible return probabilities and returns and placing them against the weighted average of the sum” (Investopedia.com).

None of the information in this document should be considered as tax advice. Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

How to Use Alternative Minimum Tax Balancing to Manage Incentive Stock Option Cash Flow

Last Updated on September 16, 2020 by Daniel Zajac, CFP®, AIF®, CLU® 1 Comment

If you have employee stock options, you need to determine what kind you have: incentive stock options (ISO) or non-qualified stock options (NQSO).

The differences go far beyond their names. ISOs may provide tax advantages for you, assuming you meet certain requirements. For this reason, many people prefer incentive stock options over NQSOs.

But with the tax advantages come increased complications. The rules around qualifying vs. disqualifying dispositions and the alternative minimum tax can make creating a strategy for your ISOs challenging to do.

What can help is understanding the ins and outs of these rules, how your cash flow may be impacted depending on what you choose to do, as well as tactics you can implement to make the most of your options while minimizing risk and making tax-smart decisions.

If you are looking for a solution that allows you to exercise and hold as many shares as possible and limit the cash call required, an AMT balancing strategy might be the best option for you.

How Qualifying Dispositions Work (and Where Alternative Minimum Tax Matters)

First, you need to understand what counts as a qualifying disposition. This occurs when you sell your ISO shares at least 1 year past the exercise date and 2 years past the date the shares were granted.

Selling incentive stock options this way allows you to pay long-term capital tax rates on any realized gains from the exercise price of the options to the final sale price. But while paying a lower tax rate may sound attractive, exercising and holding your ISOs for at least 1 year that may pose a potential cash-flow problem.

You need to consider how you’ll pay the tax due on the exercise and hold of your options, and you’ll also need to figure out how to pay for the exercise price of the stock shares.

The tax due that may be due is the alternative minimum tax, or AMT. The larger the spread between the exercise price of the ISO and the fair market value of the stock, the larger the potential for AMT.

It’s not uncommon for that spread to be so large that the subsequent tax bill exceeds the amount of cash you have on hand (or at least, requires a cash call much larger than the amount of cash you’d want to send off to the IRS).

One way to manage this potential cash flow problem is to plan an exercise, hold, and sell strategy that focuses on cash flow first. Doing so gives you a way to use AMT balancing when you exercise your ISOs.

The Potential Cash Flow Problem of an Incentive Stock Options Exercise

When you exercise and hold incentive stock options, you may be subject to AMT — and you will be subject to paying the cost to exercise and hold the shares. Let’s assume the following hypothetical scenario to see how much cash these moves could force you to use:

Amount of incentive stock options you can exercise: 10,000
The exercise price of your ISOs: $1.00 per share
Fair market value at exercise: $26.00
Alternative minimum tax rate: 26%

If you exercise and hold 10,000 ISOs, the bargain element is an AMT preference item; this is what you report when figuring if you owe AMT.

In our example, the bargain element is $250,000. If we assume a simple flax 26% AMT rate, that means you owe $65,000 in AMT.

In addition, you also need to pay for the shares of stock when you exercise and hold. In our example, this means paying another $10,000 ($1 per share multiplied by the 10,000 ISOs exercised).

Assuming these numbers, you’d pay a total of $75,000 to exercise and hold these stock options.

If you don’t have the cash on hand (and have it available to use for this specific purpose), you have a problem — but AMT balancing could help you solve it.

Using Alternative Minimum Tax Balancing to Solve the Cash Flow Problem with Exercising Incentive Stock Options

AMT balancing is a method that can help you cover the estimated cash required to pay AMT and for the shares you exercise by using some of the proceeds generated by exercising and then selling a portion of your ISO shares.

This means that, in lieu of an exercise and hold of 100% of your incentive stock options, you exercise and hold some ISOs while you exercise and sell some of the others.

The proceeds of the ISOs you sell can then be used to pay the tax bill and the cost to buy the shares. This is one of the biggest benefits of AMT balancing: you’ll end up holding a smaller position in company stock, but you’ll also reduce how much cash you need to pull out of pocket to cover the exercise transaction itself.

In addition to limiting or eliminating the amount of cash flow required to exercise and hold your ISO shares, AMT balancing can also help limit your exposure to a single company stock. The reduced position you’d most likely have (versus exercising and holding all your shares) may be a good thing if you are risk-averse, seeking to diversify your portfolio, or don’t want such a large amount of your net worth tied up in the same company that signs your paychecks.

Another benefit of AMT balancing is immediately realizing profits. Realized profit is something you don’t receive when you have ISOs that you exercise and hold. Holding shares means you continue to assume the risk/reward tradeoff associated with a single stock position, which may not align with your overall financial plan or investment strategy.

How Alternative Minimum Tax Balancing Works

Let’s go back to our example above to help illustrate how AMT balancing can work. We already established that the total cash necessary to pay the AMT and to exercise and hold your ISOs is $75,000.

If you used an AMT balancing strategy instead of exercising and holding all your shares, you’d need to ask, “How many ISOs need to be sold immediately after exercise to end up in a cash flow neutral position?”

To calculate the shares required, you divide the total cash you need to cover your expenses and taxes by the fair market value of the stock. (Note that this assumes that you exercise and sell the required ISO shares immediately.)

In our example, the number of shares required to be sold is:

Estimated Shares Required to be Sold = Cash Need / FMV of the Stock

$75,000 / $26.00

2,884 Shares (rounded down)

Total Proceeds from the Sale = $74,984

Post-sale, the $74,984 in proceeds can be used to pay the pending AMT bill as well as to cover the cost to buy the shares. This means that you will need to pay $16 out of pocket and that you will retain 7,116 shares post-transaction (the 10,000 ISO shares you started with, minus the 2,884 you sold to cover costs).

A Detailed Look at a More Complex Alternative Minimum Tax Balancing Scenario

Income tax rules for incentive stock options, the AMT, and compensation income tax rates will likely make a real-life scenario more complex to work through than the simplified example we used above.

In fact, as you exercise and hold some ISOs and exercise and sell others, you transition into a world that includes both AMT preference item reporting and compensation income reporting. This means that different tax rules will apply to different portions of the exercise transaction.

ISO shares that will be sold in a disqualifying disposition because they are exercised and sold rather than held will be subject to compensation income tax rates. In our example, 2,884 shares would be subject to this kind of tax treatment.

Meanwhile, the ISO shares that were exercised and held would be subject to AMT (assuming they are held past year-end). In our example, that’s 7,116 shares subject to AMT rates.

If we illustrate the qualifying and disqualifying disposition separately and show the cash flows from each transaction, we can see more clearly the cash flows required to exercise and hold the ISOs, the proceeds from the exercise and sale of the disqualifying disposition, and the AMT and compensation tax due:

	Qualifying Disposition	Disqualifying Disposition
Shares	7,116	2,884
Cost of Shares	($7,116)	($2,884)
AMT (26%)	($46,254)	0
Proceeds from Sale	$0	$74,984
Compensation Income (24%)	$0	($17,304)
Net Cash Flows	($53,370)	$54,796

By adding the net cash flows from the two portions of the transaction, you can see a positive total cash flow of $1,426. This is where AMT balancing can help you break even or even have a net cash flow, and not pay cash out of pocket

(It should also go without saying that you should complete a personal tax projection to determine how this strategy may work for you and what the exact figures may be. Using an expert who understands the complexities around equity compensation and how various parts of that compensation will be taxed can be extremely valuable.)

What AMT Balancing Means for Incentive Stock Options and Your Comprehensive Financial Plan

Much of the attention pertaining to incentive stock options address the AMT, AMT credits, and potentially preferential tax treatment. Unfortunately, these conversations may fail to address a similarly important part of the conversation: cash flow.

By giving attention to cash flow, you can begin to understand how your exercise decisions may impact you in the near term.

You need to know how much cash you will need to exercise and hold shares, whether or not you can actually afford a specific ISO strategy, and where the cash will come from if you’ll use it to exercise and hold shares.

By answering these questions, you can begin to implement a strategy that addresses your investment risk tolerance, your tax preference, and your ability to fund the plan per your other assets. Only then can you decide whether an AMT balancing strategy is in your best interest.

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.

9 Year-End Planning Tips for Your Equity Compensation

Last Updated on April 15, 2020 by Daniel Zajac, CFP®, AIF®, CLU® Leave a Comment

You might not give much thought to the equity compensation you receive throughout the year (until you’re forced to take action with it). But even if you do have a long-term plan in mind, it’s smart to pause periodically and review the overall strategy.

The end of the year is a prime opportunity for this review, and also provides a chance to check in and recall any decisions made during the calendar year. Not only will this allow you to stay abreast of your current situation, it may be the right time to implement decisions that could have a material impact on your investments, income tax, and cash flow in this year or the next.

Here are 9 considerations to keep in mind during a year-end review of your equity compensation.

1 – Take Stock of What You Have (and What You Have Done)

The end of the year is a good time to take an inventory of your equity compensation package. This may start with a simple review of what’s included.

Do you have incentive stock options, non-qualified stock options, restricted stock units, an employee stock purchase plan, or stock appreciation rights? Know what you have and make sure you have a basic understanding of the rules and important information around each type of equity comp in your package.

Next, consider a more detailed review of individual grants. Individual grant review can provide you more granular detail such as vesting dates, expiration dates, exercise price, and other key information.

Grant information may also lead you to explore your previous exercise history, any AMT that might be due or any AMT credits coming back to you, vesting history, and current stock owned outright.

This year-end process is about understanding what you have, what you can do with it, when you can do something, and what planning opportunities may arise. You can only make sound decisions around properly coordinating your equity compensation with your financial plan if you know what you have and what actions you’ve already taken.

2 – Exercise Incentive Stock Options Shares Up to the AMT Crossover Point

If you hold in-the-money incentive stock options and do not expect to owe alternative minimum tax when projecting your tax return, you may want to consider exercising your ISOs so that the bargain element is just enough that your tentative minimum tax is equal to your regular minimum tax.

The net result of this transaction means that you will exercise and hold just enough ISOs that you will not owe AMT.

One benefit of this AMT crossover strategy is that you begin the holding period requirements to achieve a qualifying disposition of your exercised-and-held ISOs. A second benefit is that you do so without the commonly-required cash outlay required if you exercised ISOs to cover the AMT.

Keep in mind there is risk associated with this strategy. Even though you may not owe AMT on this type of exercise, you will be required to pay for the exercise cost of the shares themselves. This requires you to put cash (or its equivalent) into the transaction — and in theory, you could lose that money if the stock price drops in value.

You should also be aware that this strategy may or may not make a material impact on how many ISO shares you have exercised and held, versus how many you control. If you have a lot of ISOs, this may only allow you to exercise a few of them, but it does provide the benefit of beginning the holding period for a qualifying disposition.

3 – Sell Incentive Stock Option Shares That Are Down in Value

Year-end is a good time to review the current value of any incentive stock option shares that you exercised and held early in the calendar year.

If the prevailing fair market value of the stock is lower than fair market value on the date you exercised, you may want to evaluate the opportunity to sell these shares and intentionally create a disqualifying disposition.

When you exercise and hold, the bargain element is a determining factor in whether or not you owe AMT. If the bargain element is big, it may lead to a large AMT bill.

But if the stock price drops between the time you exercise and the end of the year, you may find yourself wishing that you hadn’t exercised because the cost of the AMT is going to unaffordable (or, at the very least, undesirable).

Assuming this is the case, selling the shares that were exercised and held early in the calendar year will “undo” the AMT preference item requirement and eliminate your AMT bill. Selling in this scenario leads to a disqualifying disposition, and you will likely need to pay ordinary income tax on the spread between the exercise price and the final sales price of the stock.

While paying ordinary income may not seem as desirable as paying long term capital gains, a falling stock price post-exercise and the ability to undo AMT might create a situation where it could be just the right opportunity for bigger-picture income tax planning and cash flow planning.

4 – Review the Possibility of Accelerating an AMT Credit

The alternative minimum tax is a bit like a prepayment of expected income tax on your exercised and held incentive stock options. But this prepayment often requires you to pay more in taxes than you otherwise would have, leading to a net cash flow.

Eventually, when you sell your ISO shares in a qualifying disposition, you might have the opportunity to receive your AMT back in the form of a credit.

If you have qualifying ISO shares, the end of the year could be a good time to evaluate whether or not you should sell those shares. Selling the shares may not only result in reduced position in company stock and a positive cash inflow from the proceeds, it may result in receiving your AMT credit back sooner rather than later.

5 – Review Your Strategy for Vested Restricted Stock and Exercised Non-Qualified Stock Options

Generally speaking, when restricted stock units (or awards) vest and you exercise non-qualified stock options, each type of compensation is taxed as ordinary income and paid to you via a cashless transaction.

A cashless transaction means that the value of the unit or option is paid in company stock, after subtracting some amount for income tax withholding (usually 22%). But you don’t need to keep the shares simply because the value of the equity compensation was paid to you in shares.

The end of the year is a good time to evaluate whether or not you should keep those shares, or sell them.

If you want to limit your concentrated position in a single stock, selling shares obtained during the calendar year may be an attractive strategy. If the prevailing market price is near the price at which the shares vested or were exercised, the additional tax implications to sell may be minimal as you only need to pay capital gains (loss) on the amount in excess of the cost basis.

From a cash flow standpoint, this may mean you will receive nearly the full proceeds of the sale. You can then use these proceeds to address some of your other financial planning goals and objectives.

6 – Consider Liquidating ESPP Shares

Much like RSU and NQSOs, you should evaluate your ESPP at year-end. Participation in a good ESPP that offers a discount on the purchase price and a lookback provision can be a good reason to participate in the plan to your fullest capability.

Retaining company stock in an effort to achieve a qualifying disposition and preferential tax treatment, on the other hand, may or may not be as attractive as it seems. To do so, you have to hold the ESPP shares for at least a full year after receiving them, which subjects you to the market risk of owning a single stock.

Consider your ESPP strategy and how much you currently participate. Do you need to make adjustments to bring that strategy in line with your overall financial plan or risk tolerance? Should you retain or sell your ESPP shares to accomplish that?

These are important questions to ask when reviewing your current use of an ESPP.

7 – Evaluate the Opportunity to Accelerate Income into This Calendar Year

If you find yourself in a low-income tax year, or expect to be in a significantly higher tax bracket next year, it may make sense to accelerate some of your income into this calendar year. Generally speaking, accelerating income can be accomplished in two ways:

First, you can accelerate income by exercising non-qualified stock options.

When you exercise NQSOs, the bargain element is treated as compensation income in the year of exercise. Another consideration may be to exercise and sell your ISO as a disqualifying disposition. This transaction may also have the impact of accelerating ordinary income into this calendar year.

A second option may be to sell previously held stock.

If you hold shares that have experienced a long-term capital gains outright, selling those shares may mean you are able to capture the gains at a preferential tax treatment. If your income is low enough, your long-term capital gains may not be taxed at all.

8 – Evaluate Your Projected Income Tax Due (and See If You Might Get a Refund)

In a year that you have restricted stock that vests and/or stock options that you exercised, projecting and paying income tax can be complicated. Year-end can be a good time to project your tax return to see if you have paid enough tax to cover your tax bill.

To do so, you might want to consider a few things:

First, you should calculate what you expect to owe in income tax for the year. This may include income tax from RSUs and NQSOs that will be subject to ordinary income tax treatment, or from AMT and/or capital gains taxes more commonly associated with ISOs.

Once you know what your tax bill is projected to be, you can determine if you have withheld enough via payroll deductions and estimated tax payments to cover the projection.

Companies will often withhold income tax on RSUs and NQSOs at a statutory federal income tax rate of 22%. (With ISOs, you usually won’t have any money withheld from your paycheck.) This may or may not be enough to cover your total tax bill, so this is important to figure out even if your company already withheld some money from your salary.

If you feel as though you underpaid your income tax, you may want to make an estimated tax payment to cover the need, or set aside cash to pay the tax due when your return is prepared.

9 – Plan for Next Year

As part of a year-end review, you might want to evaluate whether or not you have RSUs that vest, stock options that are set to expire, or ISOs that will meet the qualifying disposition standard.

If you understand what is expected and project a future tax return, it may lead to planning opportunities such as coordinating equity compensation with other employee benefits like a nonqualified deferred compensation plan, or an increase in your current 401(k) deferral rates.

This may also lead to opportunities around cash flow planning. If you expect a large sale of stock or a large vesting of RSUs, you want to plan for what you will do with the proceeds. This is where proactive financial planning may come in to play.

If You Want to Make the Most of Your Equity Comp, Plan a Year-End Review

Year-end planning for equity compensation is more than an arbitrary timeline at which to review your needs. It’s a time when income tax, cash flow, and investment risk can all be materially impacted by decisions (or non-decisions) prior to the close of business on December 31.

While the list above is not a complete list of planning considerations, it does provide a primer in to some of the things you may want to consider.

Keep in mind, however, that each one of these topics can be complicated, and by combining several into a coherent plan may require the skills of an accountant, a financial planner, an investment guru, and most important your personal goals and objectives.

Planning for Incentive Stock Options: How Exercising ISOs Could Impact Your Cash Flow

Last Updated on April 15, 2020 by Daniel Zajac, CFP®, AIF®, CLU® Leave a Comment

Before you do anything with your incentive stock options, you need to get clear on how exercising those ISOs could affect your assets and what will it cost you in terms of real money.

You need to know the cost of exercising your options, for example, or what you might pay in alternative minimum tax. And perhaps more importantly, you need to know where the money to pay for the pending cost of your decision will come from.

Understanding your cash flow plays a big role in making the right choices with your ISOs. By strategizing appropriately around the reality of your cash flow, you may be able to better time and plan for whatever exercise strategy you may be considering.

A Simple Look at How Exercising Incentive Stock Options Can Impact Your Cash Flow

When you exercise incentive stock options, you generally need to address two cash calls. The first is when you need to pay the exercise cost for your options. The second is when you pay the alternative minimum tax.

To calculate the required cash necessary to exercise your incentive stock options, you can multiply the number of shares you will exercise by the exercise price of your ISOs.

Calculating the cash necessary to pay the expected alternative minimum tax is more complicated. For purposes of this article, we can simplify this if we assume a flat AMT rate of 28% for all of our examples. (But if you’d like to learn more about AMT specifically, start here.)

If we assume an AMT rate of 28%, you can multiply that by the bargain element to calculate your estimated cost, and therefore the amount of cash required to pay alternative minimum tax.

Your bargain element is:

(Number of Shares Exercised) x (Fair Market Value at Exercise – Exercise Price)

Calculating the Cash Necessary to Exercise Incentive Stock Options: A Specific Example

Let’s assume that you have 10,000 incentive stock options with an exercise price of $5 per share and a current fair market price (FMV) of $100 per share. You plan to exercise and hold the incentive stock options post-exercise with the goal of obtaining a qualifying disposition.

In this scenario, the total cash call required is equal to the exercise cost of the shares, plus the AMT you owe from the exercise. Here’s how to calculate your cost to exercise:

(Number of Options Exercised) x (Exercise Price Per Share)

10,000 x $5 = $50,000

You will need to put up $50,000 to buy your shares. Then you need to account for the taxes generated from your exercise. The AMT cost, in this example, would be:

(AMT Rate) x (Bargain Element)

28% x $950,000 = $266,000

This tells us that you would need $316,000 in cash on hand (which is the cost of your shares at $50,000 plus the $266,000 you owe in AMT) in order to cover all the costs associated with exercising your incentive stock options.

A Strategy to Cover the Cash Required to Exercise Incentive Stock Options

There are two potential problems that are most common when people want to exercise and hold incentive stock options. The total cash call necessary for this transaction may be either:

So high that you cannot afford it.
So high that you don’t want to afford it.

$316,000 is a lot of money to have lying around in cash, and many people aren’t in a position to drop this kind of money all at once. Even if you do have this much liquidity available, you still might have very good reasons to not spend it all at once on your options.

If you find yourself in either scenario, you could reduce the cash needed for the transaction by exercising and holding some shares, and exercising and selling others. In other words, you could intentionally execute a disqualifying disposition.

This strategy uses the proceeds from the immediate exercise and sell to cover the total cost of the exercise and hold and the AMT that generates. Let’s go back to our example above to see how this works.

We know the total cost of an exercise and hold is $316,000. If you want to (A) exercise and hold as many shares as possible and (B) not use (or at least minimize) your own cash for the transaction, you will need to sell some of your options immediately via a cashless exercise.

In order to estimate how many options you need to sell in a cashless exercise, you can divide the total cash call necessary by the bargain element of the incentive stock option:

(Cash Call) / (Bargain Element) = Cashless Shares

$316,000/$95 = 3,327

This strategy suggests that you sell the 3,327 shares. That would generate (approximately) enough proceeds to cover the cash outlay required to hold the remaining 6,673 shares.

Checking the Cash Flow of an Estimated Cashless Exercise of ISO

This seems simple, but you still may need to do further analysis to determine if this makes sense for you — and to understand if you might need to put up some amount of cash even if you try a cash-to-cover type of exercise.

Remember that only the shares exercised and held are subject to the alternative minimum tax. The others you exercised and sold are subject to ordinary income (or the rules for a disqualifying disposition).

For the 6,673 incentive stock options shares your exercised and held, the bargain element is subject to AMT is $633,935. Assuming AMT of 28%, the total due is $177,502.

For the 3,327 shares that you exercised and sold, the bargain element of those shares will be taxed as compensation income. Again, that amount is $316,065. If we assume a flat 34% tax, you owe $107,421 for these shares. And finally, you still need to buy the shares for $50,000.

Adding these three cash calls together, we calculate that the total cash required for the transaction is $334,923. This is offset by the proceeds of selling 3,327 shares at $100 per share, or $332,700.

There is still a net required cash call of $2,223, which you will need to address even if you do a sell-to-cover type of transaction.

Using Timing to Manage Cash Flow When Exercising Incentive Stock Options

The above scenario is a simplified example that illustrates the shares required to perform a seemingly net cash flow neutral exercise. However, by understanding the timing of when the cash flows are required, it may allow for further planning opportunities.

When you exercise and hold incentive stock options, you must pay for exercise cost at the time of exercise. The AMT, however, is not due until you file your tax return.

Generally, that happens in the year following the year you exercise and hold. But you may still want to consult with your advisor to determine whether or not you should consider making an estimated tax payment in the year of exercise.

It Is this cash flow timing consideration that may add an additional layer of complexity to the conversation. To illustrate this, let’s now assume you exercise your incentive stock options early in the calendar year and that you plan to pay AMT when it is due when you file taxes in the following year.

When you exercise, the required cash will be $50,000, or 1,000 shares multiplied by $5 per share.

To cover the cost of the shares, you will need to sell 500 shares immediately as a disqualifying disposition. This leaves you holding 9,500 shares (or 2,827 more shares than you did in the cashless exercise above).

The potential benefit, as you can see, is a greater number of shares retained.

(Whether or not this is a good idea or a bad idea from an investment and financial planning standpoint is a different conversation. Before you choose any particular exercise strategy, you should understand the impact of taking large positions in company stock.)

The total tax due is also different in this situation.

The 500 shares that are sold as a disqualifying disposition will be subject to ordinary income. With a bargain element of $47,500 and a tax rate of 34%, the total due is $16,150.

For the 9,500 shares you exercised and held, the bargain element is $902,500 and the AMT is $252,700. These amounts, both the AMT and the ordinary income tax, are not due until tax time.

This may allow for you to hold 9,500 shares until you meet the one-year qualifying disposition requirement. Once you do, you can sell some of the shares, obtain long term capital gains treatment, and create an AMT offset that may lead to a future AMT credit.

When the time comes to pay tax, you can use some of these shares to cover the tax cost. If the share price of the stock is still $100 per share, you will need to sell 2,527 shares to generate the required proceeds of $252,270. After selling the 2,527 shares, you will now retain 6,973 shares.

This type of strategy may be suitable if you want to maximize your control over your shares but don’t have the cash to simply exercise and hold all of them. However, this approach may come with additional risk.

The stock price might decrease between your exercise early in the year and the time your sell the shares the following year. If it does, you may have been better off simply selling your shares and paying the tax immediately.

Exercising in a down market might also force you to pay more in AMT than you want, or more than the stock is worth. However, year end planning may be able to undo such a scenario.

What Does This Tell Us About Exercising Incentive Stock Options?

Much of the talk regarding incentive stock options centers around the alternative minimum tax. The AMT is a byproduct of seeking a potentially more advantageous tax rate via a qualifying disposition. In order to achieve a qualifying disposition, you must hold the shares for a least one year post-exercise.

While the AMT can and should be part of the conversation if you have incentive stock options and want a qualifying disposition, you should also be aware of cash flow and how that can influence your decision-making.

Cash flow specifically speaks to how much money you need, when you need it, and how much you can offset via a disqualifying disposition. By understanding cash flow, you may be able to entirely offset the cost of your exercise right away. You may also be able to maximize the number of shares you can exercise and hold by delaying the sale of shares to cover the AMT.

These decisions are nuanced and complex, and if you’re dealing with stock options, it’s probably well worth working with a professional who can help guide you to the right choices for your goals and overall financial plan.

6 Things to Consider for Your Pre-IPO Incentive Stock Options

Last Updated on April 15, 2020 by Daniel Zajac, CFP®, AIF®, CLU® 6 Comments

The choice of when to exercise your incentive stock options can be a difficult one, with serious implications for financial planning and taxes. When your company is still pre-IPO, that opens up an entirely separate set of concerns that you may need to be aware of.

The issues associated with pre-IPO incentive stock options (ISOs) are particularly relevant now, as early-stage companies increasingly find private funding sources and delay the date of their IPO. As the length of time between startup and IPO increases, more and more employees are facing the question of the costs and benefits of pre-IPO ISO exercise.

In this article, we will look at six important things to consider if you have pre-IPO incentive stock options.

1 – How Do Pre-IPO Incentive Stock Options Work?

Most of the stock option explanations you’ll find online and in textbooks assume that the company’s stock is publicly traded. With a public market, you can easily compare the exercise price of your incentive stock options to the current trading price of your company’s stock to get a good estimate of what your options are worth. Even if you don’t plan to exercise or sell right away, you have a good baseline value to use in decision making.

In contrast, pre-IPO shares don’t trade on the open market, and therefore may not have a readily defined price. If you choose to exercise pre-IPO, the estimated value of the stock you purchase is likely based on the most recent assessment of your company’s fair value, which is calculated periodically.

You’ll likely need to wait until the next valuation to know whether or not the stock price is up or down, and whether or your exercise was a good decision.

Once you have exercised your options, you will own shares in your company. While these shares have some similarities with shares of publicly-traded companies, there are also important differences, which are discussed below.

2 – Is There an IPO Date in the Near Future?

What does it really mean to be pre-IPO? Simply that your company is not publicly traded, but may do an offering in the future. However, that is not necessarily a guarantee that the IPO will come soon, or indeed, ever.

When doing your financial planning, you should take into account the possibility that an IPO may come later than expected, if at all. More and more frequently companies may be able to secure necessary financing from venture capital and bank syndicates, which makes an IPO less urgent from management’s perspective. Or alternatively, the company simply do not grow to the point that warrants an IPO.

Has an IPO date been announced? Or at least a target year or quarter? Even in the case of companies that have already begun the underwriting process, IPO dates can be delayed significantly if market conditions change.

As a result, you should take contingency planning into account when thinking about your pre-IPO exercise plans. What happens if the IPO takes place later than expected? How would this affect your cash flow and tax situation? For example, what if you exercise your pre-IPO incentive stock options, pay for them in cash, pay the tax, and the lPO never occurs. You may find yourself paying cash for something that you may never get back in return. It’s best to be prepared for good and bad outcomes when dealing with uncertain future events.

3 – What If the IPO is Late (Or Never Comes At All)

If you choose to exercise pre-IPO, you will own shares of a non-public company. In some ways this is similar to owning shares of a public company, but there are some important differences.

For example, while you may be able sell your shares to another party, some instances it may not be easy to do so. Some plans may not allow for the sale of pre-IPO shares at all.

If you are allowed to sell to a third party, you will have to find someone else to buy the shares. While exchanges for buying and selling shares of private companies exist, they can be opaque and illiquid compared to public stock exchanges. You may find that you are only able to sell your shares at a price below what you consider to be fair market value.

After all, one of the most important advantages of an IPO is to provide you with an easy venue for buying and selling shares. Prior to listing, you may find this lack of venue to be an obstacle in realizing the full value of your options.

Even if you can sell, there may be restrictions on the sale of your stock pre-IPO, such as right of first refusal This means that the board or another party has the option to buy your shares from you before you can sell to a third party. Again, you should check with your plan document to see what you can and cannot do.

4 – Are You Prepared for a Lockup Period?

Once an IPO takes place, sale of your shares will likely become much easier, and pricing more transparent. However, you should be prepared for a lockup period that may restricts sale of stock. During this period, often 6 months post IPO, you may not be able to sell your shares of stock per the agreement your company has with an investment bank (the company helping your firm go public).

Of course, you may wish to hold on to your shares during this period for other reasons, hoping for stock appreciation or waiting for the long-term capital gains period to complete. Since long-term capital gains are taxed at a lower level, it may be advantageous to exercise your incentive stock options early so that you can begin the holding period requirements, meaning a post-IPO sale will be considered a long term gain sooner rather than later.

In any case, it’s important to take the lockup period into account for your financial planning, since you won’t be able to tap into the value of those shares until after the lockup period has expired should you have a sudden need for liquidity.

5 – What are the Tax Implications of a Pre-IPO Exercise?

While taxes are always important to take into account when considering the timing of exercising your incentive stock options, it’s an especially crucial consideration for pre-IPO companies. Why? Because these shares can be more difficult to liquidate, meaning you may incur a tax liability upon exercise without being able to sell some of the shares you purchased to pay your tax bill.

The tax effect of your exercise will depend on whether you hold incentive stock options or non-qualified options (NSOs). The pre-IPO sale of ISOs in particular can create tax issues, because exercise of ISOs may trigger an alternative minimum tax (AMT) liability.

The AMT is a dual tax system, where taxes owed are calculated using both the rules for ordinary income and an AMT calculation. You then pay the higher of the two numbers, AMT or ordinary income. So, by exercising your pre-IPO ISOs, you can potentially increase the overall amount of taxes you owe. However, you may also be exercising at a point when the AMT is the lowest it will be if the price continues to appreciate.

For AMT purposes, the bargain element (the difference between the exercise price and fair market value at exercise of your ISOs) may add to your income in the year of exercise.

Any pre-IPO ISOs you exercise may increase your taxes for AMT purposes, but won’t increase your regular tax liability (assuming you don’t sell your ISO shares during the year.) If your AMT taxes exceeds your regular taxes, you’ll have to pay more than you otherwise would.

The end result is that simply exercising and holding your shares can cause your tax liability to increase. If you need to sell some of your shares to cover those taxes, you may not be able to.

The tax effect is somewhat different for NSOs. Exercise of your NSOs won’t trigger an increase in your AMT liability, but the bargain element is still taxable as ordinary income. Therefore, exercise will increase your income in the year of the exercise, which can increase the taxes you will need to pay.

6 – Advantages of a Pre-IPO Exercise of Incentive Stock Options

Despite the tax issues discussed above, there can be considerable advantages to pre-IPO option exercise. Many employees of pre-IPO firms are hopeful that there could be substantial stock appreciation in the years following an IPO. If this turns out to be the case, then exercising in the pre-IPO period can have tax advantages in the long run.

For ISOs, exercising early can help to limit the total AMT effect. While the exercise itself can trigger an AMT liability (depending on the assessed fair market value of the stock), waiting several years to exercise your options could increase the AMT effect substantially if there is significant stock appreciation.

Imagine two alternative scenarios, one in which you exercise your ISOs pre-IPO, and another where you exercise two years later, after the IPO has gone to market, the lockup period has expired, and the price of the stock has appreciated.

	Shares	Exercise Price	FMV
Pre-IPO	10,000	$1	$2
Post-IPO	10,000	$1	$35

If you exercise pre-IPO in this example, your bargain element is ($2 – $1) x 10,000, or $10,000. So your taxable income for AMT purposes will increase by $10,000, limiting the possibility that you’ll be exposed to the AMT in the year of exercise. If we assume you are subject to AMT and assume at flat 28% tax rate, the total AMT bill will be $2,800.

Waiting until the post IPO period to exercise your incentive stock options, however, means that your bargain element increases substantially, to ($35 – $1) x 10,000, or $340,000. This could mean a much larger AMT liability in the future. In fact, at the same assumed 28% tax bracket, the total AMT bill is $95,200.

Of course, nobody can predict what the stock market will do in the coming years. But given the potential for price appreciation between IPO and following the IPO, you should take this possibility into account when doing your planning.

The other tax advantage of pre-IPO exercise to consider is that the clock for a qualifying disposition begins at exercise. If you exercise pre-IPO, you have begun the holding period of your stock option on the date of exercise. This means that you may achieve the qualifying disposition holding requirement when the post IPO lockup period expires. This, in turn, may give you additional flexibility to sell your ISO shares sooner than had you waited to exercise post-IPO, and still obtain potentially preferential long-term capital gains treatment.

What Now with Your Pre-IPO Incentive Stock Options

Any incentive stock option exercise decision should also be considered alongside your other financial planning needs. But as you can see, the unique issues associated with pre-IPO option exercises make careful planning especially urgent.

While there may be several advantages to a pre-IPO exercise such as a lower AMT bill or the start of your qualifying disposition holding period, the potential benefits should be weighted against the risk of buying stock that you may never be able to sell.

This conversation often circles back to good financial planning. Discussing what you are looking to achieve, what risk you are willing to assume, how much you believe in the company, and where you are in your lifecycle.

Once you evaluate the option in the scope of a larger plan, you can be informed to make a good decision about whether or not a pre-IPO exercise is a good idea for you.

Incentive Stock Options

The Mechanics of an Incentive Stock Option

Advantage 1. Simple Process for Exercising

Advantage 2. You Choose When to Exercise Your Incentive Stock Options

Advantage 3. Potential to Participate in Stock Price Appreciation

Advantage 4. Not subject to Payroll Taxes

Advantage 5. Opportunity to Obtain Long-term Capital Gains

Advantage 6. May Get Alternative Minimum Tax Back as AMT Credit

Advantage 7. Participate in the Success of the Company

Advantage 8: Managing Cash Flow Required to Cover the Cost of the Alternative Minimum Tax

What Is an Incentive Stock Option?

The Alternative Minimum Tax on Incentive Stock Options

The Impact of AMT on Qualifying Dispositions Versus Disqualifying Dispositions

How the AMT Credit Impacts Your Incentive Stock Options

The Timing of When You Pay Taxes Due and Other Cash Flow Considerations

Running the Numbers: Scenarios to Compare Disposition Types for Your ISOs

Qualifying Dispositions May Look Appealing From a Tax Viewpoint

How Income Levels Impact Tax of a Qualifying and Disqualifying Disposition

Do Qualifying Dispositions Expose You to More Investment Risk?

Comparing Investment in a Single Stock to Investing Proceeds from Disqualifying Dispositions in a Diversified Portfolio

Single Stock Risk/Return May Drive Your Final Value More Than Your Tax Rate

Other Items That Can Impact the Cash Flow Analysis

Additional Planning Ideas for A Qualifying Disposition of Incentive Stock Options

What This Means for Financial Planning and Incentive Stock Options

How Qualifying Dispositions Work (and Where Alternative Minimum Tax Matters)

The Potential Cash Flow Problem of an Incentive Stock Options Exercise

Using Alternative Minimum Tax Balancing to Solve the Cash Flow Problem with Exercising Incentive Stock Options

How Alternative Minimum Tax Balancing Works

A Detailed Look at a More Complex Alternative Minimum Tax Balancing Scenario

What AMT Balancing Means for Incentive Stock Options and Your Comprehensive Financial Plan

1 – Take Stock of What You Have (and What You Have Done)

2 – Exercise Incentive Stock Options Shares Up to the AMT Crossover Point

3 – Sell Incentive Stock Option Shares That Are Down in Value

4 – Review the Possibility of Accelerating an AMT Credit

5 – Review Your Strategy for Vested Restricted Stock and Exercised Non-Qualified Stock Options

6 – Consider Liquidating ESPP Shares

7 – Evaluate the Opportunity to Accelerate Income into This Calendar Year

8 – Evaluate Your Projected Income Tax Due (and See If You Might Get a Refund)

9 – Plan for Next Year

If You Want to Make the Most of Your Equity Comp, Plan a Year-End Review

A Simple Look at How Exercising Incentive Stock Options Can Impact Your Cash Flow

Calculating the Cash Necessary to Exercise Incentive Stock Options: A Specific Example

A Strategy to Cover the Cash Required to Exercise Incentive Stock Options

Checking the Cash Flow of an Estimated Cashless Exercise of ISO

Using Timing to Manage Cash Flow When Exercising Incentive Stock Options

What Does This Tell Us About Exercising Incentive Stock Options?

1 – How Do Pre-IPO Incentive Stock Options Work?

2 – Is There an IPO Date in the Near Future?

3 – What If the IPO is Late (Or Never Comes At All)

4 – Are You Prepared for a Lockup Period?

5 – What are the Tax Implications of a Pre-IPO Exercise?

6 – Advantages of a Pre-IPO Exercise of Incentive Stock Options

What Now with Your Pre-IPO Incentive Stock Options

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