Finding the best time and best strategy to exercise incentive stock options is difficult. Competing considerations on income tax, investment planning, and financial planning make it difficult to address the best time to exercise incentive stock options (ISOs) with a blanket answer.
Some strategies suggest that exercising early may be a good idea, because this is when the impact from the alternative minimum tax, or AMT, may be lowest. Others suggest it’s best to exercise as late as you can. Waiting offers you certainty as to final value of the stock options, and your incentive stock options become a use it (exercise) or lose it (the stock option expires) situation.
Exercising early or exercising late aren’t your only two options. Instead, you might want to consider a year-end exercise to maximize the bargain element up to your regular tax base.
The 2017 tax law change made this particular strategy even more appealing. Why? Because most people want to do everything they can to avoid the AMT, including not exercising options so as not to trigger the tax.
But a year-end exercise up to the AMT crossover point strategy might provide you with a way to “have your cake and eat it too.”
With good planning, you can exercise a specific number of ISOs prior to calendar year end without incurring any AMT. In addition, this strategy begins the holding period to obtain a qualifying disposition.
Unfortunately, the details of this implementing a year end exercise up to the AMT crossover point may get a little confusing. Let’s walk through them together.
Changes in the Way Alternative Minimum Tax is Calculated Due to the 2017 Jobs Tax Act
The year-end exercise to the AMT crossover strategy has always been an option if you have incentive stock options and good tax planning skills. The 2017 Jobs Tax Act expanded that opportunity because it changed the way AMT will be calculated in 2018 and beyond.
The 2017 Jobs Tax Act made changes to increase exemptions and increase when phaseouts of said exemptions occur when calculating AMT. This is all a fancy way of saying that it is very likely less people will be subject to AMT in 2018 and beyond.
Specifically, the changes are as follows:
2017 Exemption | 2018 Exemption | 2017 Phaseout | 2018 Phaseout | |
Single | $55,400 | $70,300 | $123,100 | $500,000 |
Married File Joint | $86,200 | $109,400 | $164,100 | $1,000,000 |
For those with ISOs, a byproduct of the 2017 Jobs Tax Act may have created an opportunity for a larger AMT free exercise of incentive stock options than previously eligible.
Before we dig into a hypothetical example, let’s recap what we should already know about ISOs and the AMT.
Incentive Stock Options and the AMT
When you exercise and hold incentive stock options, you likely do so with the hope of obtaining a qualifying disposition. A qualifying disposition is one when the final sale of the stock occurs at least 2 years from the grant of the incentive stock option, and one year from the exercise date of the option.
The net result of a qualifying disposition is that the entire value from the grant price to the final sales price is treated as a long-term capital gain (assuming there is a gain in value).
What complicates this seemingly simple strategy is the AMT. AMT is based on a secondary tax calculation that occurs every year you file a tax return known as the tentative minimum tax.
As a taxpayer, you pay the higher of the regular tax calculation and the tentative minimum tax. AMT is what you pay when the tentative minimum tax is higher than the regular tax.
When you exercise and hold incentive stock options, the bargain element (the difference between the grant price and the exercise price multiplied by the number of shares exercised) is included in the calculation of the tentative minimum tax. That often makes the tentative minimum tax the higher of the two calculations, leaving you on the hook for paying AMT.
What matters when exercising ISOs up to the AMT crossover point is the spread between the two calculations. The smaller the spread between the two, the smaller the opportunity. The greater the spread, the greater the opportunity.
All else being equal, the 2017 Jobs Tax Act increased the spread between the two. This means you can likely exercise more of the bargain element than previously allowed, which leads to a greater planning opportunity.
Comparing 2017 and 2018 Tax Returns
Using a hypothetical example (and putting the numbers through actual Lacerte tax planning software), we can illustrate the impact of a higher exemption and a higher phaseout, as well as its impact on exercising and holding ISOs up to the AMT crossover point.
We will use a simple tax return with a few assumptions for our illustration:
- Our taxpayers are married couple and both spouses are 55; no kids
- They file as Married Filing Jointly on their tax returns
- They earn $250,000 of gross annual income
- They take the standard deduction
2017 Tax Analysis
When we plug the above information into the tax return for 2017, we can calculate two key numbers: regular tax and the tentative minimum tax:
- Regular Tax: $51,061
- Tentative Minimum Tax: $48,882
As the regular is the higher of the two calculations, this household will be required to the pay $51,061 in tax.
As discussed above, when planning a year end exercise strategy, you want to review the spread between the two calculations. In this scenario, the spread is $2,179.
At this point, we need to ask:
- How many incentive stock options can you exercise and still have the regular tax calculation be the higher of the two?
- How much of the bargain element (the difference between the grant price and the exercise price multiplied by the number of shares exercised) can you incur until you reach the AMT crossover point?
A simplified calculation may be as clean as dividing the spread by 28% (28% is being used as our AMT tax rate)
($51,061 – $48,822) / 0.28 = $7,782
In this simple calculation, these taxpayers could exercise and hold $7,782 of the bargain element and still pay no AMT.
If we wanted to be exact in our calculation, we could go back in time to the 2017 tax return and calculate exactly what would have happened. To do so, you enter $7,782 of bargain element into the actual 2017 tax return.
- Regular Tax: $51,061
- Tentative Minimum Tax: $51,545
The simple calculation actually forces the tentative minimum tax to be the higher of the two. Therefore, the simple calculation of the exercise and hold of $7,782 of bargain element caused our taxpayers to pay $484 of “extra” AMT.
If we further adjusted the numbers in the 2017 return, we can calculate that $6,401 of bargain element would have resulted in the regular tax and the tentative minimum tax to be exactly equal. This would have been the perfect AMT crossover point.
2018 Tax Analysis
If we transition the same exact information to a 2018 tax return using the new AMT phaseout and exemptions, we can calculate the following:
- Regular Tax: $42,819
- Tentative Minimum Tax: $36,556
Following the same simple calculation of dividing the spread between the two calculations and multiplying by 28%, we calculate that $22,367 of bargain element can be added to the tax return without incurring AMT. As this compares to $7,782 in 2017, the 2018 amount is almost 200% higher.
If we the same process and input $22,637 into a tax return, we can then calculate the following:
- Regular Tax: $42,819
- Tentative Minimum Tax: $42,442
Using the simple estimate, our 55-year-old couple could exercise $22,637 of the bargain element and pay nothing in AMT, as the tentative minimum tax is the lower of the two calculations.
This means there is additional room for more of the bargain element, as the simple calculation under estimated.
If we want to find the AMT crossover point, we can increase the bargain element until the regular tax and the tentative minimum tax equal one another. In fact, a bargain element of $24,090 in 2018 will mean regular tax will equal the tentative minimum tax at $42,819
If we sum up the information into a simple chart and circle back to the point of the article, you can see that the changing tax law allows for a greater amount of bargain element to be exercised in 2018 as compare to 2017.
Estimated Bargain Element | Actual Bargain Element | |
2017 | $7,782 | $6,401 |
2018 | $22,637 | $24,090 |
Applying These Examples to Your Incentive Stock Option Grants
Once you know the amount of the bargain element you can capture, you can circle back to your incentive stock option grants to determine how many options you can exercise. Let’s assume you have the following grants:
Shares | Grant Price | Exercise Price | Bargain Element | |
Grant 1 | 10,000 | $1.00 | $25.00 | $240,000 |
Grant 2 | 10,000 | $5.00 | $25,00 | $200,000 |
As you can see from the line on the right, if you exercised all of the grants above, you incur $440,000 from the bargain element. But the goal is to exercise only enough to reach the crossover point.
To do so, we need to calculate how many shares you could exercise to reach $24,090 of worth of the bargain element for 2018.
If we assume that you exercise shares from Grant 1, the math is as follows:
“Shares to Exercise” X (Exercise Price – Grant Price) = Intended Bargain Element
“Shares to Exercise” X ($25 – $1) = $24,090
“Shares to Exercise” = 1,003.75
If we assume that you exercise shares from Grant 2, the math is as follows:
“Shares to Exercise” X ($25 – $5) = $24,090
“Shares to Exercise” = 1,204.5
The Benefits of This Incentive Stock Exercise Strategy
If you followed the details of the above analysis, you might notice you don’t actually save income tax in the year you exercise up to the AMT crossover point. So what, if any, value does this complicated strategy have?
The first benefit is a future tax savings opportunity. If you implement this strategy correctly, you will not pay AMT (or you will pay limited AMT) on the exercised ISOs. If you do not implement this strategy, it is reasonable to assume that you’ll exercise your ISOs in a year when you are subject to AMT.
For example, in lieu of exercising some shares each year, you might exercise an entire grant of shares in 1 year. If we assume this is true, we can also assume that the ISOs will be subject to AMT in future. If they are, they will be taxed at the requisite 28% (or the appropriate AMT rate at that time).
If we compare exercising ISOs at zero cost today versus 28% later, we have a clear winner. The tax savings opportunity is 28% in opportunity cost.
(To be fair, some or all of the 28% AMT you pay may come back to you as an AMT credit in future tax years. In this sense, it’s not a total 28% savings. On the other hand, AMT also may cause a cash call need that you could avoid with the AMT crossover strategy).
The second benefit of this strategy is that it starts the holding period for a qualifying disposition of some of your shares. This means that after 1 year from exercise, you will have a portion of your shares that are eligible to be solid in a preferential tax treatment via qualifying disposition. This creates liquidity that you may not have otherwise had.
For example, imagine that you need $X amount of dollars but did not follow the above strategy. To get that money, you’d likely need to do a disqualifying disposition of ISOs, meaning a higher tax bill as you wouldn’t meet the requisite holding periods (assuming you cannot go somewhere else for the money).
A third benefit is the cumulative effect of this annual exercise strategy. In our example for 2018, you can exercise $24,090 without incurring AMT. If you do this year over year, for 10 straight years, you could exercise and hold nearly $250,000!
Ultimately, every tax situation is different and you should run a detailed tax calculation on your own (or with the help of an advisor). But the opportunity is one that should be explored if you hold incentive stock.
Summing It All Up
The year-end exercise up to the AMT crossover point is nothing new. What is new is the changing tax laws that may create additional room to exercise and hold more incentive stock options each year. As the opportunity to exercise and hold gets bigger, so does the opportunity to take advantage of this with good planning.
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.
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.
Robert Bender says
Great summary, Daniel. Thank you.
The next question becomes “what is the tax implication of exercise & hold if the held shares subsequently increase in value before a qualifying disposition”?
For example, lets say that your owner of 20,000 ISOs exercises all of them in one year (i.e. no crossover strategy). They pay $60,000 in exercise price and, incur $440,000 in bargain element, and (for the purposes of this example) lets say they pay $120,000 in AMT during the exercise year. They do not take any AMT credits the next year. Two years after exercise they have a qualifying disposition of all 20,000 shares at $50/share for gross proceeds of $1,000,000. What is used for the cost basis of the shares at the time of disposition to determine the taxable gain?
Is it
a) $60,000 (the exercise cost)
b) $180,000 (the exercise cost plus the AMT paid)
c) $440,000 (the bargain element from the exercise year)
d) $500,000 (the exercise cost + the bargain element from the exercise year)
e) Something else entirely
Daniel Zajac, CFP®, AIF®, CLU® says
Hi Rob – Thanks for the comment.
When you exercise and hold ISO, you will likely have “dual basis”. One basis for calculating your regular tax and long term capital gains, and a second AMT basis for calculating and the AMT credit.
Based on the example you used, and what I think I am reading, the basis for regular tax will be the original $60,000 exercise cost. The AMT basis will be $500,000.
When you sell the ISO shares, assuming a qualifying disposition, you will likely pay long term capital gains tax on gain from $60,000 to $1,000,000 (and maybe other tax as well https://www.danielzajac.com/4-taxes-to-plan-for-when-you-sell-your-incentive-stock-options/).
You may receive an AMT credit due to the AMT basis and how this impacts your tentative minimum tax
Keep in mind, this can be complicated. And what I have here is not specific tax advice. Its meant to be a representation of what may happen. You may want to consult a professional to help with your needs.