3 Strategies for Exercising Incentive Stock Options
Deferred-compensation tax strategies
One common way companies encourage executives to stay long-term and help build the value of the company is by issuing stock options. These options can be a boon for employees of start-ups experiencing skyrocketing growth. But the trick to making the most of this deferred compensation is smartly managing the related income taxes, especially if you have the ability to exercise them early.
Know your stock options
First, it’s important to know which type of stock option you have. Company-provided stock options essentially allow employees to buy shares of the company at a specific price at a future date, known as the strike price. There are two types: incentive stock options (ISOs) and nonqualified stock options (NQSOs). The big difference between the two is how they are taxed when you exercise them.
- ISOs — The perk of an ISO is you don’t owe ordinary income tax on day one. When you exercise an ISO, the lower 28% Alternative Minimum Tax rate applies to the difference between your strike price and the current fair market value instead of the 39.6% ordinary income tax rate.
- NQSOs — With a NQSO, you pay ordinary income tax on the difference between the strike price and the current market price when you exercise them.
Some companies offer the opportunity to exercise ISOs early — allowing the employee to buy shares at the strike price before the options are fully vested. This gives ISOs another tax advantage. When you sell the shares after holding them a year, the entire gain is treated at the lower capital gains rate of 20%.
But there are risks to early exercise of ISOs as well. You cannot sell the shares until the vesting period is over, which means the stock value could drop all the way down to zero before you can cash in. So it’s important to weigh your choices and plan carefully.
The perk of an ISO is you don’t owe ordinary income tax on day one.
When should you exercise options?
Recently, fathom told the story of Michael, an Aspiriant client who was able to meet his family’s goals by strategically following a financial plan for his deferred compensation. A big part of that plan was carefully managing his stock options over time.
When Michael started at the venture-backed software company, he was offered 250,000 ISOs at 2 cents a share. The option agreement called for full vesting of the options in four years, starting at 25% the first year, then 25% each year after that.
Assuming the fair market value at exercise was 6 cents a share, and he could later sell at 10 cents, we presented Michael with three common exercise strategies and explained the potential benefits and consequences of each:
Early exercise of all options
Michael could convert all of his unvested options and buy stock at the strike price. Because they are ISOs, he should then file for an 83(b) election with the IRS. An 83(b) election allows him to recognize AMT income equal to the difference between the market price and the exercise price on the date of exercise, even though the shares are still subject to restriction. After one year, any future gains on the shares would fall under the lower, long-term capital gains tax.
The benefit of early exercise is the tax cost now is likely to be much less than when the share restrictions lapse, assuming the share price continues to rise. But if the market value later drops, or he leaves the company before the shares are fully vested, he’s already paid tax on income he never received.
In this scenario, Michael’s total tax would be $501,800, netting him more than $1.99 million.
Partial early exercise
If Michael doesn’t have enough cash to exercise all his options now, doesn’t want to take on all the risk of full exercise, or can avoid going into the AMT tax bracket, he could buy just a portion of the stock and file the 83(b) election for those shares. The AMT preference related to the unexercised options will be deferred.
If Michael exercised half his shares, he would pay nearly $350,000 more in taxes, for a net cash flow of about $1.65 million.
The last option is to wait until all the ISOs are fully vested before exercising, or until the company is either acquired or has an initial public offering.
One reason for this approach is if early exercise pushes Michael into AMT territory, it might be better if he waits until his income is potentially lower. But, Michael may face a greater AMT tax liability because of a wider spread between the strike price and fair market value. And he would still have to hold the shares for a year after exercise to benefit from the lower capital gains rate, risking a drop in the stock price.
If he waits, he will spend almost as much in taxes ($1.2 million) as he would net ($1.3 million).
In Michael’s case, the price of the options was low. And by potentially saving $695,800 in taxes compared to doing nothing, early exercise of all his ISOs was worth the risk. However, many other choices exist for executives of start-ups, and every case is different. What worked well for Michael, your co-worker or your neighbor may not be in your best interest.
A lot to compute
If you have stock options, there are several important things to remember before exercising them.
First of all, be sure to have an attorney or certified public accountant review your deferred compensation agreement so you know exactly what types of options you have and when you can exercise them.
It’s also important to be familiar with SEC Rule 144, which dictates the holding period of your shares. An executive of a publicly traded company must hold the shares for at least six months. But if the issuer is not publicly traded, as in Michael’s case, then the shares have to be registered and held for at least one year.
A common mistake people make is they think they can file an 83(b) election on options. You can’t. The election applies to the shares received from the exercise, rather than the option itself. And then you must file for the election within 30 calendar days of exercising those shares — not business days or a 31-day month.
As you can see, there’s a lot to consider when deciding which deferred-compensation strategy is best for you. A full-service, independent financial advisory firm — that has tax accountants, investment managers and financial advisors all working for you as a team — can explain the pros and cons to make sure the best strategy is implemented with your stock options to help meet your goals for now and in the future.