Incentive stock options are unique in that the longer you wait to exercise, the costlier it may be to exercise and hold your shares. That’s not because exercising the incentive stock option cost more, as that price is fixed, but because the cost of the alternative minimum tax (AMT) may be higher.
One concern with a costlier alternative minimum tax is that it may put additional pressure on personal cash flows to pay that pending tax bill.
The larger the difference between the exercise price and the fair market value of the stock (commonly known as the bargain element), the more alternative minimum tax you may owe.
So while most of us want the share price of our stock to increase over time, and getting preferential tax treatment is always nice, too, incentive stock options may complicate the situation creating a scenario that increases the amount of the alternative minimum tax, quite possibly making it more difficult (costly) to achieve the qualifying disposition which leads to that better tax treatment, as the stock price rises.
This leads to a common question; does it make sense to exercise your incentive stock option shares earlier in an effort to minimize the alternative minimum tax?
It may – however, that strategy is not without other risk. Lets explore.
A Tangible Example of the Cost of Waiting
Let’s assume that your exercise price of 10,000 incentive stock options is $1 per share and the current share price is $10 per share. The current value of your incentive stock option is $90,000.
If the share price increases from $10 per share to $50 per share, the value of your incentive stock option grant will be $490,000.
|Number of ISO’s||Exercise Price||Hypothetical Share Price||Value|
A higher stock price is a good thing because it means that your incentive stock options are worth more. What may not be so obvious, however, is that your AMT bill likely increases as the value of the unexercised incentive stock options increases.
But it’s not all bad news. By understanding how a growing stock price impacts the AMT, you may be able to strategically plan a sound exercise strategy.
Let’s explore what happens when you exercise your incentive stock options, how your incentive stock options are impacted if you wait, and why you may want to reconsider your overall strategy.
What Happens When You Exercise Your Incentive Stock Options?
When you exercise your incentive stock options, the difference between the exercise price of the incentive stock option and the share price of the stock when you exercise, multiplied by the number of shares exercised, is a reportable event for calculating the alternative minimum tax.
For our illustrations, let’s assume a 28% flat AMT rate.
Following the example above, if you exercise and hold your incentive stock options, you will incur the following AMT.
|Number of ISO’s||Exercise Price||Hypothetical Share Price||Value||AMT (28%)|
As the value of the share price increases from $10 per share to $50 per share, the value of your ISO grant increases from $90,000 to $490,000. What also increases is the amount of AMT you will pay if you exercise and hold the ISO shares (from $25,200 to $137,200).
Why a Higher Alternative Minimum Tax May Be an Issue
It’s possible that a higher AMT may not be a problem for everyone. It can be viewed as the byproduct of an increasing stock price that generates greater and greater wealth. And if you can manage the cash flow and investment risk of an exercise and hold, it may make sense to do so.
But one area where things might be problematic is if you’re tax-averse. If you are, a significant tax bill via an exercise and hold of incentive stock options may be enough to cause you not to exercise – (even if exercising may be in your best interest).
By not exercising, you retain your potentially volatile equity position in one stock (a position that can be good or bad based on the future stock price movements) and you do not begin the holding period for a qualifying disposition.
Another potential issue might be generating cash to cover the AMT bill. If you want to exercise and hold your incentive stock options but don’t have the cash on hand to cover the pending tax bill, you might feel stuck.
Using the example above, you’d need to come up with $137,200 to pay the alternative minimum tax. Not everyone has that cash lying around available to send to the IRS.
One potential solution to the cash flow issue might be to exercise and sell some of your incentive stock options right away, using the profit generated from the exercise and sale to pay a pending tax bill.
When Alternative Minimum Tax is an Issue — But Not an Issue
Regardless of a higher alternative minimum tax and the potential issues above, it’s important to note that a rising stock price and a rising alternative minimum tax bill (all else being equal) may still be a good thing.
Your after-tax value when the share price is $50 per share is significantly higher than it is when a share price of $10 per share.
|Number of ISO’s||Exercise Price||Hypothetical Share Price||Value||AMT (28%)||After-Tax Value|
A higher stock price might require a higher AMT or a bigger cash call. But all else being equal, this is a good problem to have as compared to ending up with a lower stock price.
What If You Exercise Your Incentive Stock Options Early?
One difficult part of an exercise and hold is determining whether or not your bullish call on the stock — your assumption that the price will rise over time — is right or wrong. It may be easy to be bullish on a stock you didn’t put any of your own money into; it’s another thing to exercise and hold, funding this with other personal assets that you are now at risk of losing, and retaining that bullish mentality.
If you can get over the risk of loss associated with exercising and holding your shares, and couple this with your bullish prognostication, you may have an argument to exercise early and hold your shares over time.
For example, if the current market value is $10 and you expect the future share price to be $50, it may make sense to exercise now when the AMT is lower (only $25,200) instead of waiting to exercise later when the AMT is higher ($137,200 at a $50 share price).
By exercising early, you lower the total AMT you owe, which also limits the required cash you need to cover that bill. You also get the benefit of beginning your holding period requirements for a qualifying disposition.
How Your Financial Plan May Impact Your Decision Making
A good financial plan will likely consider when you will want to sell your incentive stock options and redirect the proceeds elsewhere. One common time for people is retirement, assuming that you have generated enough wealth to meet your financial needs for the rest of your life.
A second consideration may be a stated share price, or a stated total value of the stock options, when you are of the belief that the stock price if “fair” and you want to take your profits and run.
If you project yourself wanting to sell your incentive stock options for either reason, waiting to exercise your incentive stock options might or might not be the right strategy.
Here is the potential issue: If you exercise your incentive stock options on the same day that you reach the point you want to sell them, you may not be able to sell and obtain preferential tax treatment. To obtain the preferential tax treatment, you will need to hold them for a full year past the date you exercise. This leaves you exposed to the risk of your stock losing value, and ending up short of the wealth you need to meet your goals.
If you have incentive stock options and you meet the standard for a qualifying disposition, your realized gain from the exercise price to the final sales price will be taxed as a long-term capital gain. To obtain this tax treatment, you will need to hold your exercised incentive stock option shares for at least one year past the date of exercise prior to selling them.
Let’s assume that, based on your calculations, achieving a qualifying disposition with a share price is $50 per share will give you enough value to meet your goals.
If you exercise and sell immediately, you will not achieve a qualifying disposition. This may mean your tax bill will be higher than preferential long-term capital gains rates, and your proceeds will be less than what you need to fund your goals. This is not to say a disqualifying disposition is a bad outcome. In fact, it may be the right decision in some scenarios.
If, however, you retain the shares in an attempt to obtain the preferential tax treatment, you will be subject to the market fluctuations for at least one year. And who knows what the price will be then?
|Number of ISO’s||Exercise Price||Hypothetical Share Price||Value||AMT (28%)||After-Tax Value||Share price in 1 year|
Clearly there is a timing issue between planning when you need the proceeds of your incentive stock options, what you have to do to obtain a qualifying disposition, and how the share price performs (the ultimate unknown).
What Does This Mean for Exercise and Holding Your Incentive Stock Options?
If you are bullish on the company and you plan on holding your shares for at least an additional year, it may make sense to consider an earlier exercise of your incentive stock options.
In doing an early exercise, you may achieve the following:
- You start your holding period requirement to meet the standard for a qualifying disposition.
- Assuming the share price is higher when you sell then when you exercised your incentive stock options, you may pay less alternative minimum tax.
- You may create additional liquidity options for your stock that may be more tax beneficial than the alternatives.
While the potential benefits are many, there are also risks to consider. Namely you may be wrong and the stock price may drop. If you exercise and hold your shares, this may leave you at risk of losing real money.
Ultimately the decision to do an early exercise should be based on your goals, your risk, and your intentions for the stock in the short and long term. A good plan will address these questions at both a global level as well as an individual stock grant level.
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.