Compared with other forms of compensation, incentive stock options (ISOs) can provide executives and other employees with substantial tax breaks. If held for a certain period of time, shares purchased as ISOs may escape all taxes other than the relatively low long-term gains rate of 15%. But as many “paper millionaires” discovered during the most recent stock market downturn, exercising ISOs can be very risky, especially if the employee fails to weigh all the potential tax consequences before cashing in.
Because of their special tax treatment, incentive stock options are generally considered to be more desirable than nonqualified stock options (NQSOs). When you exercise the option to buy stock in a company under a nonqualified plan, the spread between the grant price and the market value on the day the shares were bought becomes liable to ordinary income tax immediately. If you hold onto the stock and it rises in value, you pay capital gains rates on any subsequent appreciation of the shares.
But if the options exercised were ISOs, there would be no taxes due immediately. Instead, your entire gain, including the spread and any additional appreciation, would be taxed at long-term capital gains rates, provided you did not sell the shares until at least two years after the option was granted, and one year after the date of exercise. The gain would lose its qualified status only if these holding period requirements were not met.
Sometimes, however, exercising and then holding ISOs into the next tax year can carry a very substantial hidden sting. When calculating your tax liability, you must add in the spread between the grant price and the market value as a “preference item” on the Alternative Minimum Tax (AMT) worksheet. If the amount you would pay under the AMT is higher than your regular income tax, you will be have to pay the AMT instead.
Under the AMT, you are taxed at rates of 26% and 28% on the amount of your taxable income above the exemption amounts. For 2015, these are $53,600 for singles or heads of household, and $83,400 for married filing jointly. The AMT exemptions phase out gradually at higher income levels.
Some employees who held onto their company’s shares for more than a year after exercising ISOs have found themselves in the unfortunate position of owing more in AMT taxes than their shares were actually worth.
Suppose, for example, you exercised an incentive option to buy 1,000 shares in your company at your grant price of $25 a share, at a time when the shares were trading at $175 on the open market. On paper, your gain would be $150,000. If you decided to hold the shares for at least a year in hopes of minimizing your taxes and enjoying additional appreciation, the AMT could be triggered and you would become liable to pay income taxes on your $150,000 gain.
This tax burden might not feel too onerous if, after, a year, you were able to sell the shares at a price of $185. But if your company’s share price were to fall dramatically before you sold your stock, to $35 a share, your gain will have shrunk to $10,000, but the IRS would still demand AMT payment on your original spread of $150,000. To help offset your losses, you can claim an “AMT credit” in future years. But many taxpayers who have found themselves in this situation have been forced to borrow money to pay the IRS, arrange payment plans, or even declare bankruptcy.
Fortunately, there are ways to reduce the chances of falling into this trap. Depending upon your circumstances, you may want to consider the following strategies when exercising your incentive stock options:
Sell your shares immediately after exercising your ISOs. In doing this, you would forfeit the tax advantages that come with qualified options, but you would remove the risk of running up a large AMT bill. This strategy might make sense if you have little or no financial cushion, or if your company’s share price tends to be volatile.
Exercise your ISOs incrementally. Most employees have a window of five or more years between the time their stock options are fully vested, and the expiration date of the options. While you may feel tempted to wait until close to the deadline to exercise your options in anticipation of getting a higher share price, this strategy carries risks. You can plan to buy small quantities of shares in each of these years, to avoid having a large transaction that would trigger the AMT. If you have extra money to invest, consider using it to diversify your portfolio.
Exercise your ISOs at a time when the share price is unusually low. This strategy may be counterintuitive, but it makes sense to minimize the spread between your grant price and exercise price for the purposes of taxation. If you are lucky, the share price will have rebounded by the time you are ready to sell. If it continues to fall, you will at least have dodged a large tax hit.
Exercise your ISOs early in the year. By exercising your options in January or February, you are giving yourself plenty of time to weigh up whether you would be better off holding onto the shares to take advantage of the long-term gains rate, or whether you should dispose of your shares by December 31 to avoid getting saddled with a large AMT bill.
Take other steps to reduce your chances of having to pay the AMT. If you cannot avoid having a large spread when you exercise your options, you may be able to lower your income or minimize your deductions in other areas to avoid triggering the AMT.
Choose not to exercise the options. Remember that, from your perspective, a stock option is not worth the paper it’s printed on—and could even turn into a liability—until it’s converted into cash. Even if you would make a theoretical profit by exercising your options, it is essential to calculate exactly how much tax you would owe on the transaction, and when you would realistically be able to sell, should you need to do so. Ask yourself whether you would choose to invest in your company if you did not have the options. If the answer is no, you may want to resist the urge to exercise.
This is provided for informational purposes only and should not be construed as tax advice. Please consult your tax advisor.