Ready to exercise your incentive stock options (ISOs)? Then you have many strategies to consider for how and when to take the next steps.
Potential plans to implement include exercising well before the ISOs are set to expire, exercising as expiration nears, or exercising on a rolling basis (so you exercise some ISOs each year as part of a diversification strategy).
All of these, and more, are viable paths to take. The right strategy for you will depend on your personal circumstances, goals, and objectives.
That covers potential ways of exercising, or how — but you also need to consider when to exercise. Specifically, you need to choose when during the calendar year to take this action.
When You Exercise Your Incentive Stock Options Matters
When you exercise your incentive stock options, the calculation to determine if and how much alternative minimum tax (AMT) you could owe is based on a calendar year.
If you exercise your ISOs and hold the shares past that year’s calendar end, the bargain element needs to be included as a tax preference item on your tax return for the year of exercise. The potential problem is that the exercise and hold of incentive stock options may create a significant AMT bill.
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Exercising ISOs early in the calendar year may provide a solution to a big AMT bill that doesn’t require you to have cash on hand before you take action with your ISOs. If you exercise your ISOs early in the calendar year and sell these shares in subsequent shares as a qualified disposition, you can capture long-term capital gains and pay your AMT bill from the proceeds.
An early-in-the-calendar-year exercise also gives you the opportunity to undo your exercise should the stock price decrease in value from exercise and you want to sell the stock to avoid AMT.
If you combine these benefits with a desire to diversify your assets to avoid overexposure to concentration risk, you may find the best time to exercise is early on during the calendar year. Digging in deeper can help you can decide if this strategy makes sense for you.
Incentive Stock Options and the Alternative Minimum Tax
When you exercise your incentive stock options, the bargain element is a tax preference item for calculating the tentative minimum tax. This calculation impacts how much AMT you may owe.
All else being equal, a larger bargain element often leads to a higher tentative minimum tax and, therefore, a higher AMT bill. Some people feel averse to the idea of a large AMT bill that they simply don’t exercise ISOs at all — which might be a case of letting the tax wail wag the dog.
If you have substantial incentive stock options and want a qualified disposition, it’s possible that you can’t avoid paying AMT forever. Delaying an exercise of your ISOs may not entirely avoid AMT — it simply kicks the can down the line. Plus, waiting to exercise could cause you owe even more in AMT if the stock price continues to appreciate.
But the aversion to paying any kind of tax bills aside, you might just not have the money on hand to foot that bill. For example, if you exercise and hold shares from 10,000 ISOs with a grant price of $1 and a current market price of $50, your bargain element will be:
Bargain element = (Exercise Price – Grant Price) X Number of Shares
= ($50 – $1) x 10,000
= $490,000
If we assume a flat 28% AMT, you will owe:
AMT = Bargain Element x Tax Rate
= $490,000 x 28%
= $137,200
You can expect to owe $137,200 in AMT when you complete your tax return the following April (when your tax return is due). With such a big number, it’s not unreasonable to see why so many people don’t exercise at all to avoid dealing with the tax consequences.
That’s why exercising early in the calendar year might help.
Why Exercising Your Incentive Stock Options Early in the Year May Make Sense
Clearly, a cash call of $137,200 is a significant amount of money. But instead of avoiding the exercise of your ISOs, you simply need to plan ahead to determine when and how you’ll pay your AMT bill.
This is where exercising early in the calendar year comes into play. It creates an opportunity to pay your AMT bill with the exercised shares themselves, while still getting preferential tax treatment through a qualifying disposition.
Here’s a scenario to illustrate how this could work:
Say you exercise 10,000 ISOs with a grant price of $1 and a current market price of $50 on February 1, 2022. We know (from our calculation above) that this gives you a bargain element of $490,000 and creates an AMT bill of $137,200.
This bill may be due when you file your 2022 tax return, and of course, the deadline for your return is April 2023 (although you may want to be aware of required estimates and other tax nuances).
Fast forward one year. It’s now March 1, 2023, and you sell the shares you exercised on February 1, 2022. Here’s what you’ve just done by taking these actions on these dates:
- Assuming March 1, 2023, is at least two years from the grant date of your ISOs, you secured a qualifying disposition.
- When the proceeds of the sale of your stock hit your account, you can pull from these funds to pay your 2022 AMT tax bill due by April 2023; the timing solves the problem of having to pull from existing cash on hand to cover the AMT bill.
You could do even more planning to consider selling just enough of your previously-exercised shares to cover the AMT cost (and if you had met the standard for the qualifying disposition, also obtain the preferential tax treatment), rather than selling all your stock if you wanted to continue to hold some shares.
The stock price determines how many shares you need to sell should you want to sell only enough to pay AMT. If the stock price is $50 per share, you need to sell 2,744 shares ($137,200 / $50). If the stock price is $100 per share, you need to sell 1,372 shares.
Are You Too Late in the Calendar Year to Use This Incentive Stock Option Exercise Strategy?
This strategy does not work if you choose to exercise after the April timeframe.
If, for example, you exercised your shares on August 1, 20122 (instead of February 1, 2022), you would still owe $137,200 in AMT. That amount will still be due in April 2023.
But if you want to enjoy a qualifying disposition, then you can’t use the money from selling the shares you received after exercising your options. A qualifying disposition requires that you hold your shares at least 1 year past the exercise date. If you exercise later than April, you cannot meet both the tax filing time and the 1-year holding requirement.
For example, if you sell your shares before August 1, 2023, you don’t meet the rule to hold the shares at least 1 year past the exercise date in order to enjoy a qualifying disposition. This means you cannot sell in April 2023 as a qualifying disposition. Assuming you want the better tax treatment, it’s fair to assume you will not sell, and the money for your AMT tax bill would need to come from somewhere else.
As a final “out,” it is important to know that you can sell these exercised shares to pay the tax bill. You don’t have to hold the shares for at least one year. But if you sell after holding them for less than 12 months, then your gain will be taxed as ordinary income.
Using Timing to Exercise a Large Tranche of Incentive Stock Options
Exercising your ISOs early in the calendar year is not an AMT avoidance strategy. You will need to report the bargain element and pay the AMT on the tax return for the calendar year you exercise.
What exercising early in the calendar year may do is help you manage cash flow by allowing you to use the same shares you exercised early in the year to pay the AMT in the following year.
Considering you’ll be able to use money from the sale of stock to cover the AMT due if you follow this strategy, it might also make sense to exercise a large number of options early in the calendar year.
Yes, your AMT owed will be greater — but you’ll also receive a larger amount of money from the sale of shares. You can generate cash to use for taxes and still leave yourself with the rest of the proceeds with which to reinvest in a diversified portfolio or use to fund other savings goals or lifestyle needs.
If you wish to retain shares for the long term, you can choose to only sell off enough shares to cover the cost of paying AMT. You’d have more exercised shares that meet the qualifying disposition standard. This gives you greater flexibility in how quickly and tax efficiently you can turn stock into cash.
Early in the Year Incentive Stock Options Gives You an Out at Year-End
While we always hope that the stock price goes up, your stock price can go down between the time you exercise early in the calendar year and the year end.
In this scenario, you might owe significant AMT on the bargain element value at exercise (when the stock price was high) even though the value of your stock is actually down. In a worst-case scenario, the AMT bill could be more than the value of the stock itself.
Exercising early in the calendar year gives you a chance to see how the stock performs and gives you an out should it perform poorly. The way out is to sell your exercised shares prior to the calendar year end as an intentional disqualifying disposition.
The benefit of this intentional decision is that the bargain element that would have been subject to AMT goes away if you sell your shares by year end. Your taxes owed will depend on the grant price, exercise price, and final sales price, but it’s likely you will be paying some combination of ordinary income and short-term capital gains tax.
While both of these come at less favorable rates than the original long-term capital gains tax that you’d probably rather pay, they are potentially better than holding shares that aren’t worth much and having a big AMT bill to boot.
If you’re bullish on the stock, looking to make a meaningful exercise, and/or want to generate cash to pay AMT, exercising early in the calendar year might be an appropriate strategy.
The ability to use the same options you exercised to cover the requisite tax is something that shouldn’t be overlooked. In fact, the ability may make it even more palatable to do large exercises.
A good financial plan will consider the above strategy in cohort with your own personal goals and objectives.
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.
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