Choices with Your Incentive Stock Options (ISOs)

By Laura Johnson, EA

Incentive Stock Options (ISOs) are a popular way for companies to retain and incent employees. Getting the most of your ISOs can take some planning. Here are choices an ISO holder can make, with the basic tax consequences of each. The assumption for all scenarios is that the ISOs are “in the money”. That means the current stock price is greater than the exercise or strike price, so exercising will pay off. This difference is also commonly referred to as the “spread.”

Exercise and Sell

You have a bunch of ISOs you want to exercise. You pony up the cash to exercise the options and sell the stock immediately at a nice profit.

The technical term for this is a disqualifying disposition. Think of it as additional compensation. The company, because of your talent and hard work, granted you the options. You exercise said options and sell the stock. You generated cash for yourself. Congratulations on your bonus.

Reasons you might want to do this. No risk. More cash. But…

Though this will be considered compensation, and show itself on your W2 at the end of the year, the company is NOT required to withhold federal or state tax. You may need to make estimated tax payments to avoid a penalty. Something good? The compensation is not subject to FICA or Medicare taxes.

Exercise and Hold

Here you exercise the options and then hold the underlying shares. This is the scenario, that rightfully, gets people concerned about Alternative Minimum Tax (AMT). For AMT purposes you add the spread to your AMT income even though you didn’t sell the shares. It is a very real scenario where you can end up having spent all your disposable cash exercising the options and having no cash left to pay AMT in April. Not ideal. However, with planning, ISO holders can generally avoid this result. And there are benefits to exercising and holding:

If you hold the ISO shares for more than one year and for at least two years after the options were granted, when you eventually sell them, any gain will be subject to long-term capital gains rates. Which is going to be less tax, maybe a lot less tax, than you would have paid had you sold them under the exercise and sell strategy, where your profits are higher-taxed compensation income.

But what about AMT?

You can think of AMT as a “pre-paid” tax which typically gets refunded when you sell the shares… IF the shares retained their original value or appreciated. If the share price depreciates after you exercise the options, you will be generally out of luck on getting that “pre-paid” tax back.

Cashless Exercise

Did you consider a cashless exercise? Here you aren’t the one putting up the cash to exercise the options. The brokerage firm handling the options will “loan” you the cash to exercise the options, then immediately sell enough shares to recoup the loan.

Depending on what you decide to do - sell the remaining shares or hold them for future appreciation and capital gains rates (fingers crossed) – you could be looking at a big regular tax bill from additional compensation, or an AMT bill.

The pros of this scenario are that you didn’t part with your cold hard cash to exercise the options. And you can lower risk by not putting all of your financial eggs (your job and your investments) in the same company basket.

Stock Swap

Do you currently hold company shares, along with your ISOs? If so, you may be able to swap existing shares to pay the price to exercise the options. The shares you swap out to exercise the options will retain their original cost basis. The newly acquired shares will have zero cost basis. An oversimplification here, but you get the general idea: you haven’t actually paid additional cash, but you have acquired additional shares. So, your investment remains constant in your company stock, but spread out differently across the shares you now own.

Why this is attractive? No cash outlays and no current compensation from selling shares that would be otherwise sold under the cashless exercise. But beware of the AMT adjustment as noted in the exercise and hold option.

If it sounds like ISOs can be expensive, they can be. But there is also a lot of free money on the table, subject to taxation, of course. Do you take your lumps at ordinary rates or swing for the capital rate fence? Knowing the tax implications will be important as you discuss the plan with an advisor.

At John Schachter + Associates, we help our clients plan for ISO-related events. Let us know today if we can help you!