In lieu of intentionally exercising for a strategic reason, people tend to hold their incentive stock options right up until the expiration date. At that point, people tend to exercise those options (or ISOs) because they face a “use it or lose it” situation: if they don’t exercise, the option expires, and they’ll forfeit any potential value.
Sound familiar? If you have ISOs but haven’t made a plan for them beyond “I’ll figure it out later,” you may not want to follow this path. Instead, consider setting a strategy — specifically, a strategy to exercise some or all of your ISOs early.
The Allure of Waiting
It’s understandable if you feel tempted to wait as long as possible to exercise. When you do exercise your ISOs, you create a taxable event.
The exact tax outcome (and what you owe) depends on when you exercise your incentive stock option, if you hold some or all the shares beyond the exercise date, and you when you dispose of the shares in a final sale.
But the bottom line is, you will likely owe something — and for in-the-money ISOs, the tax implications could include alternative minimum tax (AMT), ordinary income tax, and/or long-term capital gains tax. This dissuades many people from taking action if they’re tax-adverse.
In addition, waiting until your incentive stock options expire might look like an attractive approach if you want certainty. There’s always that “what if” question of, what if the value of your ISOs go up? This encourages many people to wait until they simply can’t wait anymore because of an approaching expiration date.
Dealing with your options doesn’t need to be this way, where you wait until the last second and then face a high-pressure situation to act fast before the ISOs expire. Implementing a different strategy and exercising incentive stock options early might be a better option.
Let’s explore a few reasons to consider exercising early.
1 – Exercising ISOs Early May Keep the Bargain Element and AMT Low
Exercising incentive stock options may cause you to be subject to the alternative minimum tax (or AMT) in the year you exercise. AMT is a separate income tax calculation that often impacts the tax return if you exercise and hold ISOs. The greater the spread between the market price at exercise and the exercise price (known as the bargain element), the greater the potential for AMT.
Specifically, the bargain element is calculated as follows:
(Market Price at Exercise – Exercise Price) * Options Exercised = Bargain Element
If we assume that the stock price will be higher in the future than it is now (which is certainly not guaranteed), we can also assume that the bargain element will be higher later than it will be now. It’s also fair to assume that the bargain element will be smaller now than it is later.
By having a smaller bargain element, you’ll likely lower the impact of AMT (or, put another way, the impact you do see from AMT will be lower than if you had a larger bargain element, all else being equal). If your goal is to keep the bargain element low and hopefully minimize AMT, it may make sense to exercise your incentive stock options early.
Do be aware that by exercising ISOs sooner rather than later, you not only buy the shares of stock via the option and possibly owe AMT, but you also hold company stock outright. A single stock is subject to normal market fluctuations, including the risk/reward tradeoff associated with stock positions.
In a worst-case scenario, you pay for shares and you owe AMT when you exercise. If the value of the stock then goes to zero, you lose all you originally invested to buy the shares at exercise. (This original investment would have been equal to the exercise price multiplied the number of shares exercised.)
You can compare this to a scenario in which the value of the stock goes to zero but you never exercised. Your ISOs would simply expire as worthless, and you would not have lost anything. This doesn’t mean you shouldn’t consider an early exercise, but it’s important to consider the absolute worst-case outcome before you do.
The decision to exercise early (when the spread is small) may still be wise for someone looking to minimize AMT, expecting to hold the stock for the long term, and expecting the stock to appreciate in the future.
2 – Begin the Holding Period for Qualifying Disposition of Incentive Stock Options
In order to meet the standards for a qualifying disposition of incentive stock options, a disposition that would make the profit between the exercise price and the final sale price eligible for preferential long-term capital gains treatment, a holder of incentive stock options must meet two timelines.
- The sale of the stock occurs at least two years after the grant date, AND
- The sale of the stock occurs at least one year after the option was exercised.
By exercising your incentive stock options sooner rather than later, you begin the timeline on the second standard sooner. This means that you can sell your shares in a final exercise earlier, while still obtaining a qualifying disposition, than you could have if you waited to exercise your options.
If a qualifying disposition is the goal, you might want to consider starting an exercise sooner rather than later, as you will need to wait at least one year past that exercise date to sell them. Your timeline may not work out in favor of a qualifying disposition if you wait and don’t exercise.
For example, let’s assume that you have the following incentive stock options:
- Exercise Price: $20
- Current Market Price: $100
- Price 1 Year Ago: $60
- Number of ISOs: 1,000
You can liquidate your shares now by exercising and selling — but this won’t meet the standard for a qualifying disposition because you did not wait until at least 1 year after exercise to sell. As a disqualifying disposition, profits will likely be taxed as ordinary income. In this example, that would be equal to $80,000.
(Current Market Price – Exercise Price) * Amount of Shares
(100 – 20) * 1000 = $80,000
That means, assuming a 33% tax bracket, you’ll owe $26,400 in taxes.
If you planned ahead and recognized your desire to liquidate the incentive stock options in one year, you could have initiated the process with an early exercise. You would have exercised at least one year prior to today, held the shares, and subsequently liquidated them for $100 per year.
Here’s a breakdown of how that strategy would work:
- 1 Year Prior – Exercise 1,000 options at $60 per share
- Claim the bargain element on the tax return. Bargain element equal to (Market Price at Exercise – Exercise price) * Amount of Shares
- Pay AMT as required
- At Least 1 Year Later – Sell the shares
- The final sale will be a qualifying disposition, which means you can claim long-term capital gains attributed to (Final Sale Price – Exercise Price) * Amount of Shares
- Receive (possibly) tax credit for AMT paid upon original exercise
Meeting the rules for a qualifying disposition will mean the $80,000 gain will be taxed as long-term capital gains. Assuming a 15% long-term capital gains rate, you’ll owe $12,000 in taxes ($80,000 * 15%).
That’s about half the amount you would have had to pay if you didn’t plan ahead, exercise early, and strategize for a qualifying disposition.
3 – Treat Incentive Stock Options as Compensation and Seek to Diversify*
It’s not uncommon to treat incentive stock options as cash compensation. When treating stock incentive stock options as cash compensation only, the primary goal may be to exercise and sell the options as soon as possible.
Upon liquidation, the proceeds of the sale can be diversified into other investment and asset allocation strategies. This process minimizes (or eliminates) the concentration risk associated with owning your employer’s stock.
Applying this strategy, ISOs are exercised and sold as soon as they vest. There is no consideration for meeting the standard for a qualifying disposition. The only standard is the standard that says sell and diversify, by reinvesting the profits back into a diversified investment portfolio.
The Best Incentive Stock Strategy
There is no one best incentive stock option strategy. A good strategy is one that suits your personal needs and fits into your personal plan. It’s also one that is planned out to maximize your after-tax income and meets both your short-term and long-term goals.
*Diversification and asset allocation do not guarantee a profit or protect against a loss.
The above hypothetical figures are for illustrative purposes only and do not attempt to predict actual results of any particular investment.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.
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.