As you know, vesting is always a critical moment for employee stock options.
With Restricted Stock Units (RSUs), you don’t have much control over the initial tax burden. The same can’t be said for Incentive Stock Options (ISOs).
It is critical to understand how you can take control of your ISO vesting schedule and avoid an uninvited tax storm.
ISO Basics and Tax Implications
Incentive stock options are a form of equity compensation that offers employees the "right" but not the "obligation" to purchase their company stock at a predetermined price in the future (known as the exercise price).
But you already knew that.
Did you remember, though, that to remain qualified and reap the tax rewards, you must hold your shares at least 2 years from the grant date and 1 year from the exercise date? Should you follow these rules, your profits will qualify for capital gains treatment (instead of being taxed at ordinary income tax rates).
Given this unique tax structure, many employees believe they have two choices:
- Sell all of their shares immediately after exercising (prioritizing immediate investment diversification).
- Hold all of their shares until they satisfy the long-term holding period (prioritizing ultimate tax efficiency).
While these two strategies represent the extremes, in reality, employees can choose a variety of strategies in between these “goalposts”. Depending on your unique tax and financial situation, it could make sense to sell some shares right away and hold some shares for a more extended period.
In addition to staggering the sale of your ISOs, there are some more intricate ISO tax strategies to consider.
Strategy 1: Mind The AMT Gap
In addition to staggering the sales of your ISOs, you can also stagger when you choose to exercise your options. ISOs require a 10 year offering period, allowing employees to exercise their options for 10 years following the original grant date.
This rule is fundamental when trying to limit the consequences of the Alternative Minimum Tax (AMT) system. AMT is a secondary tax system for high-income earners intended to put a floor on taxes paid.
As you know, ISOs are not taxed until you actually sell. Unfortunately, any spread between the exercise price and the fair market value on the exercise date is added as a “preference item” to the AMT tax calculation (even before you sell the shares). So what can you do about it?
- Tax Projections: With the proper knowledge about your tax situation, it’s possible to calculate how many shares you can exercise without reaching AMT levels.
- Understand The AMT Tax Credit: This is a dollar for dollar reduction in future taxes for taxes paid in previous years due to AMT. With this credit in mind, paying AMT should really be viewed as a timing issue. You might be paying additional tax now, but you can use those payments to offset future taxes on the sale of your ISOs.
- Understand AMT Balancing: This is a strategy in which you liquidate enough shares immediately to cover both the exercise cost and the expected AMT while holding the remaining shares in pursuit of a qualified disposition. Doing so allows you to keep your personal funds safe and set yourself up for long-term tax efficiency.
Strategy 2: Keep Your Eye On The Beginning Of The Year
For some investors, it makes sense to exercise their ISOs at the beginning of the year. Why is this the case?
- Selling or Holding Flexibility: Once you exercise ISOs, the 12-month holding period starts. If you exercise at the beginning of the year, you have the entire year to make a decision. If the stock price increases significantly, you could decide that it’s better to sell now (even at short-term capital gains) rather than holding on and taking the risk that there is a significant correction in the share price. Conversely, if the price declines, you might decide to not just hold beyond year-end but even beyond the 12-months holding period. Employing the AMT Balancing strategy (discussed above) can be very effective in this scenario because you have already set aside the cash for AMT, so you shouldn’t be compelled to sell shares at depressed prices to pay your tax bill. People that don’t plan for AMT can pay dearly if the market doesn’t cooperate.
- Optimizes Potential AMT Payments: Exercising at the beginning of the year shortens the time gap between when you incur AMT (during the current tax year) and selling the shares at the end of the 12-month holding period—presumably at the beginning of the following year. This means the ISO shares could be sold ahead of when the AMT bill would be due (by 4/15 of the next year).
Example: You exercise 100 shares with a $5 strike price on 1/15, creating a $500 cash outflow. The market price on the exercise date was $20. You hold the shares beyond 12/31 of that year. At this point, your AMT calculation will include the bargain element (FMV - exercise price) x # of shares exercised.
Bargain Element: ($20 - $5) x 100 = $1,500
You now need to hold the shares until 1/16 of the following year (1 year + 1 day from the exercise date). If you end up owing AMT related to this exercise event, you can sell the shares (at long-term capital gains rates) and have the proceeds of selling the shares in hand before 4/15.
In summary, the later you exercise in the calendar year, the less time you have to (1) decide if you want to hold onto the shares in pursuit of a qualified disposition and incur AMT and (2) the less cash flow you have to pay the AMT because the tax bill comes due before you even reach a qualified disposition.
Strategy 3: Coordinate Exercise Choices With Other Equity Compensation
It is prevalent for employees to have multiple types of employee stock compensation.
In addition to ISOs, many employees can expect to have access to an Employee Stock Purchase Plan (ESPP), Restricted Stock Units (RSUs), and even Non-Qualified Stock Options (NSOs). It’s essential to build a holistic strategy and avoid equity "silos.”
Working with a financial advisor and tax professional can help you create a plan that considers all aspects of your employee stock compensation in conjunction with the rest of your financial situation.
At Rivermark Wealth, we specialize in working with clients at pre-IPO companies where the ISO's transition from "monopoly money" to very tangible value as the IPO date approaches.
An IPO is an exciting date and is most certainly what you have been hoping for since joining the startup. An IPO also incites a lot of emotion, making it challenging to make rational decisions. If you find yourself in this situation, working with a financial professional can reduce your anxiety (not to mention your tax bill) and help you transfer the windfall into long-term wealth. Set up some time for us to discuss the implications of your employee stock compensation.