But what’s potentially even worse? Seeing those falling stock prices — and seeing the value of our incentive stock options (ISO) fall with them.
A falling stock price may compound your loss on the value of your ISO shares due to the inherent leverage associated with incentive stock options. Leverage with stock options means that your value can actually go up and down in value by a greater percentage than the actual change in stock price. Said another way, it means that the value of your options may go down (as calculated by a percentage) by even more than the decline in percentage decline in the stock price.
That, obviously, is not the outcome you want. But there’s a bit of good news here: if you’re bullish on the long-term value of the stock, a lower stock price may create planning opportunities for you and your incentive stock options.
A lower share price might mean the opportunity to pay less in tax. Or it could save you some money the next time you exercise, requiring less cash out of your pocket to do so. It could allow you to begin your holding period requirements earlier, or to initiate the process of diversification sooner rather than later.
For these reasons, a well-informed investor should take the time to review their financial plan to determine if the best time to exercise options is now, even if the share price is down. If you find yourself in this situation, here’s some of what you need to consider:
1 – Is the Spread On Your Incentive Stock Options Significant?
Even if the current share price of your stock is lower than what it was in the recent past, it’s very possible that the spread between the grant price and the current market price remains large.
A big spread between these two figures may mean exercising your ISOs is still the right action to take.
When you look at the value of your incentive stock options, you need to think about two types of value: the current value of your incentive stock options, and the future value of the options.
The current value, or intrinsic value, is simple and is calculated as follows:
Current Value = (Current Market Price – Grant Price) x Number of Shares
The current value is equal to the amount of money you will receive (pre-tax) should you exercise and sell your incentive stock option shares. This is often the value you see when you look at your incentive stock option statement.
A second, more complex value, is the future value of the incentive stock option (or time value).
Future value speaks to what your incentive stock options may be worth in the future should you continue to hold unexercised options. It’s not easy to calculate because no one knows exactly what will happen in the future; while you may think the stock price may double or triple, there’s no way to know for certain.
The Black Scholes Model gives us a way to at least approximate potential future value. This model uses facts such as the risk-free rate, price volatility of the stock, and time to expiration to determine what your future value may be.
Once you get a reasonable estimation of potential future value, you can use this information to determine whether or not you should exercise the shares.
Generally speaking, the greater the current value and the less the future value, the more likely it is that you’ll want to exercise. This may be true even if the price is lower today than what it was at one point in the past.
2 – Will Your Alternative Minimum Tax (AMT) Be Less?
When you exercise and hold incentive stock options, the bargain element (the spread between the grant price and the exercise price multiplied by the number of shares exercised) is a tax preference item for calculating AMT.
A large AMT bill is a common concern for those with substantial stock options — and a big enough worry to stop many people from exercising their shares.
One piece of potentially good news for a falling stock price is a smaller AMT bill (all else being equal). Here’s an example of when this might be the case:
Assume you have 10,000 incentive stock options with a current market price of $50 per share and a grant price of $5 per share. The bargain element if you exercise is:
Bargain Element = (Exercise Price – Grant Price) x Shares Exercised
Bargain Element = ($50 – $5) x 10,000
Bargain Element = $450,000
If we assume a 28% flat AMT, the AMT due is:
AMT Due = $450,000 x 28%
AMT Due = $126,000
Let’s assume however that the stock price has dropped from $50 per share to $40 per share. The new bargain element and tax is:
Bargain Element = ($40 – $5) x 10,000
Bargain Element = $350,000
Total Tax Due = $350,000 x 28%
Total Tax Due = $98,000
As you can see, a lower stock price means a lower tentative minimum and AMT bill.
To be fair, this also means your stock and stock options are worth considerably less because of a falling stock price. But if your plan is to hold the shares after you exercise them, maybe a short-term down stock price is not a big concern at all.
It all depends on your specific financial situation, which is why it’s important to discuss your options with a professional who can guide you to the choice that makes sense given your particular circumstances.
3 – Can You Exercise and Hold More Incentive Stock Options? (This Might Help Avoid AMT!)
One common strategy to exercise incentive stock options is the exercise at year-end up to the AMT crossover point. This strategy attempts to exercise just enough shares in one calendar year to make regular taxable income to equal your tentative taxable income.
The net result is that you owe no AMT — but you were still able to exercise your options.
One factor that impacts how many options you can exercise and hold is the bargain element. As discussed above, all else being equal, a lower stock price means a smaller bargain element.
As it pertains to the AMT crossover point, this means that a lower stock price actually allows you to exercise more shares at year-end, beginning your holding period for a qualifying disposition, while keeping you below the AMT crossover point.
Exercising more options is likely better than exercising less options should the stock price continue to appreciate in the future.
4 – Do You Plan to Continue the Hold the Stock Anyway?
If you plan to hold your incentive stock option shares after you exercise them, a lower stock price may be a perfect time to exercise. A lower stock price likely means you’ll pay less AMT (as discussed above).
Assuming that you sell the shares in the future for a higher price, exercising at a lower stock price will not mean a greater percentage of the overall final sale will be subject to preferential long-term capital gains treatment (should you meet the qualifying disposition standard), but it does mean that you may not need as much cash to make it work.
Let’s continue our previous example of 10,000 options with a grant price of $5. Let’s assume a final sales price of $100.
If you exercise at $30 per share with the intention to hold the shares, your $95 gain from $5 per share to $100 per share will be taxed as a long-term capital gain (assuming you meet the standard for a qualifying disposition). This may give you a long-term capital gains tax rate of 15%. You also only had to pay AMT on the difference between the exercise price of $30 and the grant price of $5.
For comparison, let’s assume that you do not exercise when the stock is down to $30 per share and instead you exercise when the stock price is $80 per share. If you exercise at $80 per share, $75 per share is subject to AMT and the same $95 is subject to long-term capital gains treatment.
The net result of a higher exercise price is a greater amount of money that you will need to use to cover the tax bill — and that’s cash that can be otherwise utilized for something else.
So if you want to hold the stock anyway and you want to limit the cost of doing so, exercising when the stock price is lower may be your best bet.
(To be fair, the scenario when you exercise at $80 per share and pay a greater AMT may still be eligible for preferential long-term capital gains treatment if you hold the shares for at least another year and meet the standard for a qualifying disposition. If you do, you may get some or all of your AMT back as a credit. However, the exercise early scenario may be better in that you’ve paid less cash for AMT at exercise and you are able to sell as a qualifying disposition a year earlier.)
5 – Can You Begin Your Holding Period for a Qualifying Disposition?
One of the great features of incentive stock options is a qualifying disposition. Meeting this standard means that you will pay long-term capital gains treatment on the entire gain from the grant price to the final sales price of your incentive stock options.
This benefit could save you hundreds of thousands in taxes, depending on how many options you have.
The difficult part is that you must hold your incentive stock option shares at least one year past the date you exercise them to obtain this benefit. (This is not the only requirement, so be sure you meet the others, too.)
Often, in an attempt to avoid paying AMT, you may find yourself holding your options as opposed to exercising them. While this does avoid paying AMT, it does not allow you to begin your holding period requirements.
A falling stock price or a lower price might be a great opportunity to exercise and hold your shares, pay less in AMT, and begin your holding period. An early exercise means an earlier date that you can sell your shares, obtain the advantageous tax treatment, and potentially diversify away into something else
6 – Do You Need to Begin the Process of Diversifying Your Assets?
A single concentrated stock position can be a great thing if your stock price continues to appreciate. In fact, a large position of a significantly increasing stock may create more wealth than what you even need to reach your goals and fund the life you want to live.
But there is, of course, absolutely no guarantee this will happen, and hoping it will happen is often too great of a risk to take — because a concentrated stock position can also lead to massive portfolio losses.
In a worst-case scenario, you could be looking at a total loss.
This risk/reward tradeoff of these wildly different outcomes is often more than a single investor and handle, which is why most people should consider a prudent decision to properly diversify their holdings.
But that does not mean the right answer is an immediate sale of your stock options. It also doesn’t mean you continue to hold the stock forever.
What this does mean is that when you diversify, you need to strike a balance between the benefits or goals of generating wealth, minimizing AMT, obtaining a qualifying disposition, and diversifying away assets as soon as possible. The magic is finding the balance that works for you.
A falling stock price may be a great opportunity to combine several of the steps above into a plan that allows you to achieve the diversification goal.
There is Often a Risk in Exercising Your Incentive Stock Options
We all want the value of our stocks and stock options to go up. The more they go up, the greater wealth we can generate.
The problem is, that investment growth is never linear. It’s a volatile experience during the day-to-day. When we look back over time, hopefully, we see a line that slowly trended upward in our favor.
Unlike with stocks we purchase outright in our portfolios, there’s a chance to view volatility and a falling share price as a potential opportunity when it comes to incentive stock options.
Instead of locking in on the value of your portfolio being down, a more prudent approach may be to look past the current value and look at the fact that you now have an opportunity on the table that could let you enjoy tax savings and help meet diversification needs.
Should you believe that the trend line of the stock will continue to be up, then exercising when the stock price is down may be your best bet — but keep in mind it takes careful planning and consideration to know the right move.
This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.