In lieu of intentionally exercising for a strategic reason, incentive stock options (ISOs) are often held until near expiration. At which point, at the risk of expiring and losing all value, the recipient of the incentive stock options will likely choose to exercise.
Upon exercise, tax reporting will occur. Exactly what reporting occurs and the ultimate tax outcome depend on which exercise strategy is being enacted. For in-the-money ISOs (the only options that would be exercised), the tax implications may include AMT (alternative minimum tax), ordinary income tax, and/or preferential long-term capital gains treatment.
This exercise strategy, to do nothing until you are forced to do something, may be right for those who are looking for certainty. Certainty in the sense that the options are at a “use it or lose it” point.
At this point, the choice is to exercise for value or not exercise and lose any and all value due to the options expiring. There is no prognosticating the future, no planning, and no guessing as to where the market will be at a later date. Due to the incentive stock options expiring, there is no later.
When not exercising means losing the value, the decision is easy.
However, it doesn’t need to be this way. In fact, for those seeking additional planning or for those who have conviction about what they want to achieve, waiting until expiration may not be the best decision.
It is possible that implementing a different strategy, exercising incentive stock options as early as possible, may actually be the best option.
While the strategy to exercise early includes possible risks, it can be suggested that with risk potentially comes opportunity.
Let’s explore a few reasons to consider exercising early.
1 –Keep The Bargain Element and AMT Hit Low
Exercising incentive stock options may cause the taxpayer to be subject to AMT (alternative minimum tax) in the year of exercise.
AMT is a separate income tax calculation that often impacts the tax return of those who exercise ISOs. The larger the spread between the exercise price and the grant price, the larger the potential for AMT. The end result of an AMT hit is paying more in tax than what would have been due had you not exercised the ISOs.
The reason? The bargain element. The bargain element is a preference item on your tax return when figuring AMT. Specifically, the bargain element is calculated as follows:
- (Exercise Price – Grant Price) * Shares Exercised
It would make sense that if one goal of exercising ISOs is to minimize the AMT impact, an early exercise may be the way to go.
Using this strategy, it may mean exercising the ISOs “sooner rather than later” when the bargain element (or spread between the grant and exercise price) is smallest (we must assume in this hypothetical example that the stock price will appreciate over time. If we do, it’s fair to assume that the bargain element will be smaller in the early years and larger in the later ones). By having a smaller bargain element, it’s relatively safe to assume that the AMT impact, if any, will be lower than if you had a larger bargain element (all else being equal).
However, in an effort to keep the bargain element lower, it must be noted that there is a tradeoff in risk. Specifically, there is a risk of losing real money.
By exercising ISOs sooner rather than later, the exerciser is now holding the stock outright. That stock is subject to normal market fluctuations, including the risk that the stock price goes to zero and the value is wiped out.
In this worst-case scenario, the exerciser of the stock will have paid for shares upon exercise. If the value of the stock goes to zero, they will have lost all they had originally invested upon exercise. This cost would have been equal to the grant price * the amount of shares exercised.
(If the value goes to zero had you not exercised, your ISOs would simply expire as worthless, and you would not have lost anything).
The decision to exercise early (when the spread may be small) may 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
In order to meet the standards for a qualifying disposition of incentive stock options, a disposition that would make the gain attributed to the difference between the grant 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.
If the goal is to sell the shares as soon as possible after meeting the standards for a qualifying disposition, an early exercise of the ISOs will likely make sense.
If a qualifying disposition is the goal, it would be logical to start the holding process as soon as possible. As soon as possible will likely be immediately upon the options vesting.
The subsequent sale will then occur immediately after the two-year holding period from when the grant date is met.
A potential pitfall may arise when planning has not occurred. For example, let’s assume that Dan has ISOs with the following attributes.
- Grant Price – $20
- Current Market Price – $100
- Price 1 year ago – $60
- Shares – 1,000
If no prior planning and no prior exercise has occurred, and Dan now wishes to sell his shares, he will need to process an exercise and sell. An exercise and sell will not meet the standards for a qualifying disposition and will therefore be taxed as ordinary income. In this example, that would be equal to $80,000.
- (Exercise Price – Grant Price) * Amount of Shares
- (100 – 20) * 1000 = $80,000
With no prior planning, that tax impact (assuming a 33% tax bracket) will be $26,400.
Assuming prior planning recognized the desire to liquidate the incentive stock options in 1 year, Dan could have initiated the process. For example, Dan could have exercised one year prior, held the shares, and subsequently liquidated them for $100 per year.
- 1 Year prior – exercise shares at $80 per share
- Claim the bargain element on the tax return. Bargain element equal to (exercise price – grant price) * amount of shares
- Pay AMT as required
- 1 year later (in this hypothetical example, the same day as listed above) – Sell the shares
- Claim final sale as qualifying disposition. Claim long-term capital gains attributed to (final sale price – grant price) * amount of shares
- Receive (possibly) tax credit for AMT paid upon original exercise
Meeting the rules for qualifying disposition will mean the $80,000 gain will be taxed as a long-term capital gain. Assuming a 15% long-term capital gains rate, the tax due will be ($12,000)
- $80,000 * 15%
Through simple planning (very simple in this sense, as we removed the AMT calculation for ease of understanding), a tax savings of over 50% is possible.
3 – Diversification*
It’s not uncommon for the holder of stock options to treat them as compensation. When treating stock incentive stock options as compensation only, the primary goal is often to liquidate the holding as soon as possible. Upon liquidation, the shares are often diversified into other investment and asset allocation strategies. This process minimizes (or eliminates) the concentration risk associated with owning employer 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.
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.
A good strategy is 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.