Before you do anything with your incentive stock options, you need to get clear on how exercising those ISOs could affect your assets and what will it cost you in terms of real money.
You need to know the cost of exercising your options, for example, or what you might pay in alternative minimum tax. And perhaps more importantly, you need to know where the money to pay for the pending cost of your decision will come from.
Understanding your cash flow plays a big role in making the right choices with your ISOs. By strategizing appropriately around the reality of your cash flow, you may be able to better time and plan for whatever exercise strategy you may be considering.
A Simple Look at How Exercising Incentive Stock Options Can Impact Your Cash Flow
When you exercise incentive stock options, you generally need to address two cash calls. The first is when you need to pay the exercise cost for your options. The second is when you pay the alternative minimum tax.
To calculate the required cash necessary to exercise your incentive stock options, you can multiply the number of shares you will exercise by the exercise price of your ISOs.
Calculating the cash necessary to pay the expected alternative minimum tax is more complicated. For purposes of this article, we can simplify this if we assume a flat AMT rate of 28% for all of our examples. (But if you’d like to learn more about AMT specifically, start here.)
If we assume an AMT rate of 28%, you can multiply that by the bargain element to calculate your estimated cost, and therefore the amount of cash required to pay alternative minimum tax.
Your bargain element is:
(Number of Shares Exercised) x (Fair Market Value at Exercise – Exercise Price)
Calculating the Cash Necessary to Exercise Incentive Stock Options
Let’s assume that you have 10,000 incentive stock options with an exercise price of $5 per share and a current fair market price (FMV) of $100 per share. You plan to exercise and hold the incentive stock options post-exercise with the goal of obtaining a qualifying disposition.
In this scenario, the total cash call required is equal to the exercise cost of the shares, plus the AMT you owe from the exercise. Here’s how to calculate your cost to exercise:
(Number of Options Exercised) x (Exercise Price Per Share)
10,000 x $5 = $50,000
You will need to put up $50,000 to buy your shares. Then you need to account for the taxes generated from your exercise. The AMT cost, in this example, would be:
(AMT Rate) x (Bargain Element)
28% x $950,000 = $266,000
This tells us that you would need $316,000 in cash on hand (which is the cost of your shares at $50,000 plus the $266,000 you owe in AMT) in order to cover all the costs associated with exercising your incentive stock options.
A Strategy to Cover the Cash Required to Exercise Incentive Stock Options
There are two potential problems that are most common when people want to exercise and hold incentive stock options. The total cash call necessary for this transaction may be either:
- So high that you cannot afford it.
- So high that you don’t want to afford it.
$316,000 is a lot of money to have lying around in cash, and many people aren’t in a position to drop this kind of money all at once. Even if you do have this much liquidity available, you still might have very good reasons to not spend it all at once on your options.
If you find yourself in either scenario, you could reduce the cash needed for the transaction by exercising and holding some shares, and exercising and selling others. In other words, you could intentionally execute a disqualifying disposition.
This strategy uses the proceeds from the immediate exercise and sell to cover the total cost of the exercise and hold and the AMT that generates. Let’s go back to our example above to see how this works.
We know the total cost of an exercise and hold is $316,000. If you want to (A) exercise and hold as many shares as possible and (B) not use (or at least minimize) your own cash for the transaction, you will need to sell some of your options immediately via a cashless exercise.
In order to estimate how many options you need to sell in a cashless exercise, you can divide the total cash call necessary by the bargain element of the incentive stock option:
(Cash Call) / (Bargain Element) = Cashless Shares
$316,000/$95 = 3,327
This strategy suggests that you sell the 3,327 shares. That would generate (approximately) enough proceeds to cover the cash outlay required to hold the remaining 6,673 shares.
Checking the Cash Flow of an Estimated Cashless Exercise of Incentive Stock Options
This seems simple, but you still may need to do further analysis to determine if this makes sense for you — and to understand if you might need to put up some amount of cash even if you try a cash-to-cover type of exercise.
Remember that only the shares exercised and held are subject to the alternative minimum tax. The others you exercised and sold are subject to ordinary income (or the rules for a disqualifying disposition).
For the 6,673 incentive stock options shares your exercised and held, the bargain element is subject to AMT is $633,935. Assuming AMT of 28%, the total due is $177,502.
For the 3,327 shares that you exercised and sold, the bargain element of those shares will be taxed as compensation income. Again, that amount is $316,065. If we assume a flat 34% tax, you owe $107,421 for these shares. And finally, you still need to buy the shares for $50,000.
Adding these three cash calls together, we calculate that the total cash required for the transaction is $334,923. This is offset by the proceeds of selling 3,327 shares at $100 per share, or $332,700.
There is still a net required cash call of $2,223, which you will need to address even if you do a sell-to-cover type of transaction.
Using Timing to Manage Cash Flow When Exercising Incentive Stock Options
The above scenario is a simplified example that illustrates the shares required to perform a seemingly net cash flow neutral exercise. However, by understanding the timing of when the cash flows are required, it may allow for further planning opportunities.
When you exercise and hold incentive stock options, you must pay for exercise cost at the time of exercise. The AMT, however, is not due until you file your tax return.
Generally, that happens in the year following the year you exercise and hold. But you may still want to consult with your advisor to determine whether or not you should consider making an estimated tax payment in the year of exercise.
It Is this cash flow timing consideration that may add an additional layer of complexity to the conversation. To illustrate this, let’s now assume you exercise your incentive stock options early in the calendar year and that you plan to pay AMT when it is due when you file taxes in the following year.
When you exercise, the required cash will be $50,000, or 1,000 shares multiplied by $5 per share.
To cover the cost of the shares, you will need to sell 500 shares immediately as a disqualifying disposition. This leaves you holding 9,500 shares (or 2,827 more shares than you did in the cashless exercise above).
The potential benefit, as you can see, is a greater number of shares retained.
(Whether or not this is a good idea or a bad idea from an investment and financial planning standpoint is a different conversation. Before you choose any particular exercise strategy, you should understand the impact of taking large positions in company stock.)
The total tax due is also different in this situation.
The 500 shares that are sold as a disqualifying disposition will be subject to ordinary income. With a bargain element of $47,500 and a tax rate of 34%, the total due is $16,150.
For the 9,500 shares you exercised and held, the bargain element is $902,500 and the AMT is $252,700. These amounts, both the AMT and the ordinary income tax, are not due until tax time.
This may allow for you to hold 9,500 shares until you meet the one-year qualifying disposition requirement. Once you do, you can sell some of the shares, obtain long term capital gains treatment, and create an AMT offset that may lead to a future AMT credit.
When the time comes to pay tax, you can use some of these shares to cover the tax cost. If the share price of the stock is still $100 per share, you will need to sell 2,527 shares to generate the required proceeds of $252,270. After selling the 2,527 shares, you will now retain 6,973 shares.
This type of strategy may be suitable if you want to maximize your control over your shares but don’t have the cash to simply exercise and hold all of them. However, this approach may come with additional risk.
The stock price might decrease between your exercise early in the year and the time your sell the shares the following year. If it does, you may have been better off simply selling your shares and paying the tax immediately.
Exercising in a down market might also force you to pay more in AMT than you want, or more than the stock is worth. However, year end planning may be able to undo such a scenario.
What Does This Tell Us About Exercising Incentive Stock Options?
Much of the talk regarding incentive stock options centers around the alternative minimum tax. The AMT is a byproduct of seeking a potentially more advantageous tax rate via a qualifying disposition. In order to achieve a qualifying disposition, you must hold the shares for a least one year post-exercise.
While the AMT can and should be part of the conversation if you have incentive stock options and want a qualifying disposition, you should also be aware of cash flow and how that can influence your decision-making.
Cash flow specifically speaks to how much money you need, when you need it, and how much you can offset via a disqualifying disposition. By understanding cash flow, you may be able to entirely offset the cost of your exercise right away. You may also be able to maximize the number of shares you can exercise and hold by delaying the sale of shares to cover the AMT.
These decisions are nuanced and complex, and if you’re dealing with stock options, it’s probably well worth working with a professional who can help guide you to the right choices for your goals and overall financial 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.