Incentive stock options are a type of equity compensation you may receive as part of your overall compensation package. Incentive stock options, or ISOs, allow you to buy company stock at a fixed price for a set period of time, regardless of the current fair market value of the stock.
In the best circumstances, incentive stock options can be a tool to generate significant wealth if your ISOs have a low exercise price (the price you can purchase the stock via the option), the stock price is substantially higher than the exercise price, or both.
Incentive stock options also come with tax advantages that other types of equity compensation, like non-qualified stock options, don’t have. For example, you can secure a qualifying disposition if you exercise your ISOs and hold those shares of stock for at least 1 year post-exercise and at least 2 years post-grant. That lets you pay long-term capital gains on the spread between the exercise price and the final sales price of the stock, rather than the more expensive ordinary income tax rate.
There are other strategies you might want to use to manage and mitigate your tax burden associated with incentive stock options, as well. Here are 6 ways that might work for you.
1 – Carefully Consider the Timing of Exercising and Selling Incentive Stock Options in the Calendar Year
An exercise of your incentive stock options and a sale of shares of stock you own create a reportable taxable event. The exact tax implications may vary, depending on the time between when you exercise and when you sell.
- If you exercise early in the calendar year, you begin the required 1-year holding period necessary to eventually sell the shares as a qualifying disposition. A qualifying disposition means securing the preferred long-term capital gains rate.
- Exercising early in the calendar year may set you up to sell your shares as a qualifying disposition prior to the tax being due for the calendar year, meaning that you can use the proceeds of the sale of shares to cover the pending tax due.
For example, you could exercise your ISOs in January of the current year, hold them until you sell at least one year and one day later the following January, then use the proceeds from the sale to cover the tax bill that will be due that April.
Exercising early in the calendar year also gives you the chance to watch the stock price and make decisions based on this. If the stock price is the same or higher by the end of the year, you’d probably want to follow the actions outlined above.
Otherwise, if the stock price dropped, selling sooner than the year mark might make more sense. This would leave you with a disqualifying disposition, meaning any gain would be taxed at less favorable ordinary income rates. But it also means there won’t be an AMT adjustment for the calendar year.
Exercising early in the calendar year gives you more time to see how the stock performs prior to being locked into an AMT adjustment. It also allows you a chance to better understand your overall income for the year.
If you get to the end of the calendar year and have not yet taken action on your ISOs, you may want to take a hard look at the options available to you. This is because as year-end approaches, you can most accurately project your income tax return for the year.
In doing so, you can best estimate if you have room to exercise and hold shares up to the AMT crossover point (the point where you do not incur AMT). Then, you can project the AMT due up to what you can afford to pay from cash flow or stock sale proceeds.
2 – Exercise and Hold Incentive Stock Options When the Spread Is Low
You may be able to mitigate the alternative minimum tax impact associated with an exercise and hold of incentive stock options by exercising when the spread between the exercise price of the option and the fair market value of the stock is small.
All else being equal, a smaller spread between the two prices means a smaller adjustment on your tax return for figuring the AMT, and subsequently a smaller tax due. It’s possible, in fact, that the AMT adjustment when the spread may be so small that you can exercise and hold ISO without paying AMT at all.
Exercising and holding options with a low spread may be an attractive strategy for those who receive incentive stock options from a company that has not yet gone through an initial public offering (IPO). The spread between the exercise price of the ISO and the fair market value of the stock is so small in that case that the AMT adjustment will be small as well, leading to little or no tax.
The difficult part of exercising and holding pre-IPO stock is that your company may be far away from any liquidity event. That leaves you vulnerable to putting real money into a stock purchase that may never trade on a public exchange, where you could hope to make a return on your investment.
Even still, this is something to consider as part of an overall financial plan. In addition, you may want to consider this if you are eligible for an 83(b) election of your incentive stock options (early exercise) or annual up to the AMT crossover point.
3 – Be Mindful of the Alternative Minimum Phaseout and “Extra Tax”
AMT is calculated differently from the figures used to determine your regular tax obligations. Part of this calculation includes an AMT exemption and an AMT phaseout at certain income levels.
Specifically, in 2021, these are as follows:
- AMT Exemption:
- Married filing jointly: $114,600
- Single filers: $73,600
- AMT Phaseout:
- Married filing jointly: $1,047,200
- Single filers: $526,600
Generally speaking, when your income for figuring the AMT enters the phaseout range, you lose $1 of exemption for every $4 of income until the exemption is zero. The practical impact on your AMT means a higher effective tax rate in the phaseout range.
While the typically flat tax rates of 26% and 28% for figuring AMT are still used, the amount of income subject to taxation is higher because of the phaseout. That leads to an effective AMT rate of 35% in the phaseout range.
This phaseout may also impact the taxability of long-term capital gains for years you are subject to AMT, potentially increasing your effective tax rate from 20% to 26.5% or 27%, based on your personal circumstances.
4 – Plan for the Alternative Minimum Tax Credit and the AMT Carryforward
If you exercise and hold incentive stock options and pay AMT because of this event, it’s possible to recover the AMT in future years via an AMT credit.
The AMT credit may be accelerated in the year that you sell shares you held from previously-exercised ISOs. Selling qualified shares can be a negative adjustment on the calculation of the AMT, leading to a larger potential for the AMT credit.
You can also plan ahead to secure the AMT credit. If you have multiple qualified ISO shares with differing regular cost basis (exercise price of the stock) and AMT cost basis (share price at exercise), you may be able to pick and choose which shares to sell in order to accelerate the AMT credit sooner rather than later.
In some scenarios, the full amount of AMT paid could be credited back to you in the year you sell your shares.
Or, you may have carryforward AMT credit for years into the future (especially if you owe a lot in AMT). Good planning in advance of exercising your ISOs and holding shares can help you plan how much AMT credit you may carry forward, and how to implement an ISO management strategy with this in mind.
5 – Exercise and Hold Your Incentive Stock Options While Selling Other Qualified ISO
If you exercise your incentive stock options and hold the shares past the calendar year end, you’ll need to make an adjustment on your tax return on form 6251, and you may owe AMT. The larger the difference between the exercise price of the ISO and the fair market value of the shares at exercise, the greater the adjustment and the greater the likelihood you’ll owe the alternative minimum tax.
Depending on how much you owe, it might not be possible for you to afford the AMT out of pocket when it’s due at tax filing time. That might stop you from exercising more ISOs… even when you would like to do so to start the holding period to secure a qualifying disposition in the future.
However, if you plan to exercise and hold some ISO in one year, you could take previously-exercised and held ISOs that already count toward a qualifying disposition (those that have been held at least 2 years from grant and 1 year from exercise) and sell those.
Selling qualified ISOs, particularly ones that are worth at least the fair market value at exercise, may result in a negative adjustment on form 6251. That may reduce AMT owed, and therefore could negate or mitigate the cost of the other exercise in the same calendar year. If you plan to exercise and hold ISO while also selling others, particularly when you have shares at a regular loss or AMT loss, you’ll want to be mindful of wash sale rules
6 – Exercise Incentive Stock Options in a High Income Year
Years in which you earn a high income can be an opportune time to exercise your incentive stock options and hold the shares.
Generally speaking, tax rates for ordinary income and for AMT purposes flatten out as income increases above a certain amount. When this happens and your ordinary income is taxed at 37% (in 2021) and AMT is taxed at 28%, every dollar of earned income creates an additional spread for exercise and holding incentive stock options.
Often, this may occur in years when you have substantially higher income due to high bonus payouts, RSUs vesting, exercising other equity compensation like non-qualified stock options, or going through a double-trigger IPO event.
You can also plan to receive other income, where appropriate, in a year that you plan to exercise your ISOs. For example, you may want to max out your 401(k) contributions, including after-tax contributions if eligible, in years you have extra cash flow from the sale of stock. Planning how to max out an ESPP may also be a good idea.
Or, if you’re in retirement, you may want to push IRA distributions to a future year if you have qualified sales and capture long-term capital gains rates in a low-income tax year.
Mitigating Tax and Maximizing your Incentive Stock Options
If you have incentive stock options and are seeking to maximize after-tax value, it’s important to take a prudent look more than a simple calculation for AMT and long-term capital gains. As you can see from the article, there are many areas of planning that can be coordinated to optimize your plan.
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.