If the value of your Company’s stock declined significantly after you exercised Incentive Stock Options (ISO’s), you may have a tax problem.
Did you exercise and hold?
A common strategy with incentive stock options is to exercise and hold your ISO’s for over one year to get favorable capital gain rates when you sell your shares. You may may pay alternative minimum tax (AMT) for the year in which you exercise, you can recover some of the AMT in a later year through a minimum tax credit.
Exercise and Hold ISO Strategy
No ordinary income tax
May owe AMT
Recover AMT in future years
Sell after one year
Pay long-term capital gains
This approach to handling your incentive stock options can be beneficial if the stock price continues to appreciate. If the stock price drops significantly, however, this can result in overpaying the alternative minimum tax and not being able to recover the AMT in later years.
Incentive Stock Options and Alternative Minimum Tax
When you exercise and hold your ISO’s, you do not generate any taxable income for regular tax purposes, but you create income for purposes of calculating AMT. The AMT is a separate tax you pay in addition to the regular income tax.
The difference between your exercise (strike) price and the market value of the Company’s stock on the date you exercise is income for purposes of calculating the AMT. The amount of AMT you owe is dependent on the value of the Company’s stock at date of exercise.
Income for AMT = (Stock Price – Exercise Price) x Shares Exercised
The higher the market value, the more AMT you pay. But what happens if the stock value drops after the date you exercise? In this scenario, you still owe the AMT based on the higher value at date of exercise even though your stock may be worth substantially less now.
How to avoid the higher AMT tax bill
If you find yourself in this situation, you should consider selling your shares before the end of the calendar year in which you exercised. By doing so, you will not owe any alternative minimum tax on the shares you exercised and sold. Instead you will have ordinary income to the extent of your actual gain.
Income = (Lower Stock Price – Exercise Price) x Shares Sold
Working at a tech company in San Francisco with a salary of $150,000 or more, the tax savings can be significant.
Let’s say that in January you exercise 10,000 shares of incentive stock options. Your exercise price is $10 per share, and the company stock is trading at $45 per share on the day you exercise.
Income for AMT = ($45 – $10) x 10,000 = $350,000
With a $150,000 in salary and taking the standard deduction, you will owe $136,350 in taxes for the year including $106,060 in AMT related to your exercise.
But, January marked a high point in the value of your company stock. By December, the price has declined by 20% to $36 per share.
You decide to sell to avoid paying alternative minimum tax on the value of the stock at the time you exercised.
Income = ($36 – $10) x 10,000 = $260,000
You now owe $116,246 in Federal income tax with zero dollars in AMT related to the exercise of your shares. You save $20,104 in taxes by selling your shares.
There is no AMT tax credit to be potentially lost in future years, you save money on taxes now, and the cash from the sell plus money saved on taxes can be put to work in your investment plan.
Seven Steps to Put This Strategy to Work for You
All things related to stock options and taxes involve important details. Getting everything right will save you money. Here are the steps to follow.
- Exercise your Incentive Stock Options in January
There are a couple of reasons why exercising in January makes sense.
Doing so will give you the most time to determine if holding or selling is the right move for you. If the stock price goes up, you can be happy. Your AMT bill on the exercise is smaller than it would have been at the higher price and more of your gain will be converted to long-term capital gains at a lower tax rate. But, you will have more time to decide to sell if the stock price goes down. Exercising in January gives you more time to choose.
Exercising in January pays off the following year if you decide to hold and sell after one year. Your one year holding period will be up at the start of the next year. You will have more time to plan now for next year’s sell and time to choose when to sell next year.
- Monitor the stock price
Our normal investment advice is to develop a thoughtful investment plan built around your goals and then ignore the day to day movements of the stock market.
But, we take a different approach here. For this strategy to work, you will need to check-in regularly on how the stock price has changed since you exercised. You may also have to plan around black-out periods. Know when your block-out periods are and plan to check on the stock price at the start of each trading window.
- Update your tax projection
We update our client’s tax projections throughout the year to make sure that we know the impact of employing tax strategies like the one described here. You need to do the same.
Have you received a raise at work? Are you buying a house this year? Getting married? Having a baby? Selling other investments or property?
Almost every life change that has a financial component will show up on your tax return in one way or another. Stay on top of the changes. Keep your tax plan up to date.
- Decide what to do in December
December will be the moment of truth. You must sell by the end of the year. With your updated tax projection, you can decide if selling makes the most sense for you.
- Properly record your basis
It is important to properly record your basis to avoid getting double taxed on incentive stock options that are exercised and sold in the same year. You are selling to lower your taxes. Make sure you get the full benefit by properly recording your basis and adjusting the basis on your tax return if needed.
- Sell and reinvest
Don’t let cash from the sell of your incentive stock options sit idly in your bank or brokerage account. Put that money to work.
Stock options are a big part of your investment plan. Once you sell, you need to know how to reinvest the proceeds so that your investments continue to support your goals.
- Plan for the tax bill
No matter if it is the alternative minimum tax or the ordinary income tax, with your great tech salary, exercising or selling those incentive stock options is very likely going to create an April 15 tax bill. Plan now and set aside the funds you will need in advance.
Get Started Today
Planning for stock options and taxes is hard, but the potential tax savings are huge. We can make it easy. Start by scheduling a call today.