Incentive stock options are unique in that the longer you wait to exercise, the costlier it may be to exercise and hold your shares.
That’s not because exercising the ISOs cost more, as that price is fixed, but because the cost of the alternative minimum tax (AMT) may be higher.
Most of us want the share price of our stock to increase over time. Getting preferential tax treatment is always nice, too. So let’s say you exercise and hold your incentive stock options for a least one year to meet the standards for a qualifying disposition, which sets you up for that better tax treatment.
Over that period of time, your stock price rises — another good thing, right? Remember that a rising stock price means a rising bargain element, too. As a result of the higher bargain element, you can expect a bigger AMT bill.
It’s one big reason waiting to exercise your incentive stock options may cost you.
A Tangible Example of the Cost of Waiting
Let’s assume that your exercise price of 10,000 incentive stock options is $1 per share and the current share price is $10 per share. The current value of your incentive stock option is $90,000.
If the share price increases from $10 per share to $50 per share, the value of your incentive stock option grant will be $490,000.
|Number of ISO’s||Exercise Price||Hypothetical Share Price||Value|
Clearly, a higher stock price is a good thing because it means that your incentive stock options are worth more. What may not be so obvious, however, is that your AMT bill grows with the value of the unexercised incentive stock options.
But it’s not all bad news. By understanding how a growing stock price impacts the AMT, you may be able to strategically plan a sound exercise strategy.
Let’s explore what happens when you exercise your ISOs, how your ISOs are impacted if you wait, and why you may want to reconsider your overall strategy.
What Happens When You Exercise Your Incentive Stock Options?
When you exercise your incentive stock options, the spread between the exercise price and the share price when you exercise, multiplied by the number of shares exercised, is a reportable event for calculating the alternative minimum tax.
For our illustrations, let’s assume a 28% flat AMT rate.
Following the example above, if you exercise and hold you will incur the following AMT.
|Number of ISO’s||Exercise Price||Hypothetical Share Price||Value||AMT (28%)|
As the value of the share price increases from $10 per share to $50 per share, the value of your ISO grant increases from $90,000 to $490,000. What also increases is the amount of AMT you will pay if you exercise and hold the ISO shares (from $25,200 to $137,200).
Why a Higher AMT May Be an Issue
It’s possible that a higher AMT may not be a problem for everyone. It can be viewed as the byproduct of an increasing stock price that generates greater and greater wealth. Nothing wrong with that.
But where things could get problematic is if you’re tax-averse. If you are, the fear of a significant tax bill via an exercise and hold of ISOs may be enough to cause you not to exercise — even if exercising is in your best interest.
By not exercising, you retain your potentially volatile equity position in one stock (a position that can be good or bad based on the future stock price movements) and you do not begin the holding period for a qualifying disposition.
Another potential issue might be generating cash to cover the AMT bill. If you want to exercise and hold your ISOs but don’t have the cash on hand to cover the pending tax bill, you might feel stuck.
Using the example above, you’d need to come up with $137,200 to cover AMT. Not everyone has that cash lying around available to send to the IRS (although one potential solution is using the profit generated from the exercise and sale of the ISO shares themselves).
When AMT is an Issue — But Not an Issue
Regardless of a higher AMT and the potential issues above, it’s important to note that a rising stock price and a rising AMT bill (all else being equal) is still a good thing.
Your after-tax value when the share price is $50 per share is significantly higher with the higher stock price.
|Number of ISO’s||Exercise Price||Hypothetical Share Price||Value||AMT (28%)||After-Tax Value|
A higher stock price might require a higher AMT or a bigger cash call. But all else being equal, this is a good problem to have as compared to ending up with a lower stock price.
The difficult part is determining whether or not your bullish call on the stock — your assumption that the price will rise over time — is right or wrong. It is easy to be bullish on a stock you didn’t put any of your own money into; it’s another thing to put money on the table, at the risk of losing it, and retaining that bullish mentality.
If you can get over the risk of loss associated with exercising and holding your shares, and couple this with your bullish prognostication, you may have an argument to exercise early and hold your shares over time.
For example, if the current market value is $10 and you expect the future share price to be $50, it may make sense to exercise now when the AMT is lower (only $25,200) instead of waiting to exercise later when the AMT is higher ($137,200 at a $50 share price).
By exercising early, you lower the total AMT you owe, which also limits the required cash you need to cover that bill. You also get the benefit of beginning your holding period requirements for a qualifying disposition.
How Your Exit Point from the Stock May Impact Your Decision Making
Your exit point is the point in time you will want to sell your shares and redirect the proceeds elsewhere. One common exit point for people is retirement, assuming that you have generated enough wealth to meet your financial needs for the rest of your life.
A second exit point may be a stated share price, or a stated total value of the stock options, when you are of the belief that the stock price has topped out and you want to take your profits and run.
If you find yourself wanting to sell your ISOs for either reason, waiting to exercise your incentive stock options might not be the right strategy.
If you have ISOs and you meet the standard for a qualifying disposition, your realized gain from the exercise price to the final sales price will be taxed as a long-term capital gain. To obtain this tax treatment, you will need to hold your exercised ISOs shares for at least one year past the date of exercise prior to selling them.
Here is the potential issue: If you exercise your ISOs on the same day that you reach your exit point, you may still need to hold them for one more year to obtain the preferential tax treatment. This leaves you exposed to the risk of your stock losing value, and ending up short of the wealth you need to meet your goals.
Let’s assume that, based on your calculations, achieving a qualifying disposition with a share price is $50 per share will give you enough value to meet your goals.
If you exercise and sell immediately, you will not achieve a qualifying disposition. This may mean your tax bill will be higher than preferential long-term capital gains rates, and your proceeds will be less than what you need to fund your goals.
If, however, you retain the shares in an attempt to obtain the preferential tax treatment, you will be subject to the market fluctuations for at least one year. And who knows what the price will be then?
|Number of ISO’s||Exercise Price||Hypothetical Share Price||Value||AMT (28%)||After-Tax Value||Share price in 1 year|
Clearly there is a timing issue between planning when you need the proceeds of your ISOs, what you have to do to obtain a qualifying disposition, and how the share price performs (the ultimate unknown).
What Does This Mean for Exercise and Holding Your ISO’s?
If you are bullish on the company and you plan on holding your shares for at least an additional year, it may make sense to exercise your ISOs earlier.
In doing an early exercise, you may achieve the following:
- You start your holding period requirement to meet the standard for a qualifying disposition.
- Assuming the share price is higher when you sell then when you exercised your ISOs, you pay less in AMT.
- You create additional liquidity options for your stock that may be more tax beneficial than the alternatives.
While the potential benefits are many, there are also risks to consider. You may be wrong and the stock price may drop. If you exercise and hold your shares, this may leave you at risk of losing real money.
Ultimately the decision to do an early exercise should be based on your goals, your risk, and your intentions for the stock in the short and long term. A good plan will address these questions at both a global level as well as an individual stock grant level.
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.