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Understand your 5 strategic options and select the best one for your financial plan.
Incentive stock options (ISOs) are one of several types of equity compensation you may receive as a tech employee.
Intended to retain key talent, incentive stock options give employees of a given company the right to buy company shares at a fixed price.
Being granted ISOs is exciting but it’s merely the first step of a long, wealth-building process.
Your next step is to devise an ISO exercise strategy to really set yourself up for success.
The key is building a clear ISO exercise strategy that’s grounded in the fundamental principles of how incentive stock options work.
This post outlines the five ISO exercise strategies you have to choose from. Read on to figure out the best course of action for your financial plan.
5 ISO exercise strategies
One of the fun parts of advising professionals with incentive stock options is, there’s no one-size-fits-all approach to it.
That’s because your grant, company, and opportunities for liquidity are unique to you.
As such, you must build an ISO exercise strategy around your specific situation.
There are three overarching strategy categories to consider for your incentive stock options:
- Exercise and hold
- Exercise and sell
- Wait and exercise later
Within these categories are five ISO exercise strategies, which you can think of as a menu of choices you can make.
We’ll take a closer look into each of your five strategy options below.
Exercise & hold
There are three ways you can exercise and hold your incentive stock options:
Early exercise and hold
When your company grants you incentive stock options, they follow a vesting schedule. In most cases, you must wait for the options to vest before you can exercise them and hold the shares. But with an early exercise and hold strategy — keyword “early” — you can exercise and hold your shares before the options vest. Check your ISO grant agreement to see if there’s a provision for early exercise to find out if this is an option for you.
This strategy can help lower taxes you may pay when you eventually sell the shares. It’s also designed to help you dodge the alternative minimum tax (AMT) and start the clock on your long-term capital gains (LTCG) holding period. While beneficial, early exercise and hold strategies also involve more specific rules and may require greater attentiveness than their traditional counterparts. With an early exercise and hold, you’ll need to use an 83(b) election, which is an IRS form that may allow you to pay taxes based on your equity’s value on the grant date, before it vests.
Another key to successfully employing this strategy is to do it early, meaning soon after you receive your ISO grant and hopefully at a time when your exercise price is low. This would ideally take place in the early days of your company, when both your exercise price and cost of exercise (i.e. the number of options you’re exercising multiplied by the exercise price) are low. It’s also ideal to do this strategy when your exercise price and the fair market value are similar, as a narrow delta would help you avoid the alternative minimum tax.
Exercise and hold without the AMT
This strategy focuses on dodging the alternative minimum tax. Your tax situation, as it relates to the AMT, determines the number of incentive stock options you’d exercise here. When devising this strategy for clients, we do a tax projection and estimate the number of ISOs they can exercise without triggering the AMT.
Once the client has executed this strategy and (hopefully) avoided the alternative minimum tax, our plan from there is to hold on to the resulting shares. Exercising and holding introduces a secondary choice they must make: deciding when to sell the shares.
When determining the best time to sell your shares as part of your ISO exercise strategy, you’re really only dealing with two possibilities:
- The first one is to sell the shares two years after grant or one year after exercise. By doing so, the shares will qualify for long-term capital gains, potentially helping you avoid the AMT on the exercise and getting the lower LTCG tax rate on the sale.
- You can also exercise and hold without the AMT and then sell either within two years of grant or within a year of exercise. This method is called a disqualifying disposition because it disqualifies your ISOs, subjecting them to non-qualified stock option (NSO) treatment (yes, that means you’ll have to pay a higher tax rate). Though it entails higher taxes, a disqualifying disposition can still be a solid strategy for you. We’ve certainly seen clients amid dramatic, post-IPO price spikes that were so attractive we encouraged them to disregard taxes and do a disqualifying disposition. Sure, dodging the alternative minimum tax is nice, but your ultimate goal isn’t achieving the long-term capital gains tax rate; your primary goal is to sell your equity at the highest possible price. Price is always paramount to other decision-making factors, like taxes.
Exercise and hold with the AMT
There are cases where triggering the alternative minimum tax isn’t as big of a concern. Instead, you can go all in, exercise everything, and trigger the AMT. Or perhaps you trigger the AMT without necessarily exercising everything.
To help professionals navigate this strategy, we sometimes identify a total budget for their ISO exercise, which is an amount they’re comfortable spending on both the cost to exercise and the AMT. Once we identify the total budget, we work backwards to calculate how many of their ISOs we can exercise while sticking to their budget.
Similarly to its without-AMT counterpart, exercising and holding with the AMT gives you a secondary choice: deciding when to sell the shares. If you hold your shares and sell them two years after grant or one year after exercise, the sale will be taxed as a long-term capital gain. But an important detail is that because you paid the AMT on the exercise, you now have additional details that need to be reported correctly on your tax return. These details include the cost basis of your shares for the regular income tax and the cost basis for your shares under the AMT. Make sure that the sale is reported correctly on both tax calculations, you’re not overpaying taxes on the sale, and you’re getting as much of the minimum tax credit back as possible.
With a disqualifying disposition, where you’re selling either within two years after grant or one year after exercise, there are even more details to keep up with. If your disqualifying disposition occurs in the same year as your exercise, your situation may involve AMT that’s now gone, leaving the sale of your shares as the only tax event (the taxes of which would be based on the price at which you sold). In this case, your options would receive NSO treatment and be taxed as ordinary income. On the other hand, if the exercise occurs in year one and your disqualifying disposition in year two, you’ll have two different taxable events on your hands, not to mention plenty of tax details to keep up with. We always encourage employees to work with a qualified tax professional, but it’s especially recommended in complex situations like disqualifying dispositions. Even a minor reporting error can cost you tens or hundreds of thousands of dollars in taxes. Don’t let bad tax work mess up your ISO exercise strategy. Work with someone who knows what they’re doing.
Exercise & sell
A unique feature of the exercise and sell strategy is that you can execute it as a single event. We call this transaction a cashless exercise.
How it works is you execute your cashless exercise through your brokerage company. The administrator of your equity rewards plan both exercises the options and sells the resulting shares. They then withdraw the cost of the exercise from the sale.
This strategy’s one-transaction nature makes it simple to execute. Its taxes are also more straightforward because there is no AMT to worry about, it’s taxed as ordinary income, and the event is naturally contained in a single calendar year. Another advantage of the exercise and sell strategy is that there’s no out-of-pocket cost for you.
To execute this strategy, simply treat your ISOs using our preferred approach for NSOs: Watch the stock until it reaches a price at which you’re happy to sell. Then, execute your exercise and sell strategy, pay the taxes you owe, and reinvest the cash into your investment plan.
Wait & exercise later
The final strategy for exercising your incentive stock options is to wait and exercise later… or wait and do nothing at all.
One of the greatest upsides of ISOs is that they have a fixed exercise price and a variable stock price. That means no matter how the stock price may change, your exercise price remains the same. If you’re uncertain of how the stock might perform or if you’d rather hold onto your cash and avoid complications of the AMT, waiting and exercising later — or waiting and doing nothing — can be a perfectly sound strategy.
Tailor your ISO exercise strategy to your needs
You may not know it, but it’s quite common for professionals to have multiple incentive stock option grants. If that’s the case for you, you could pursue multiple ISO exercise strategies across your different grants. Each strategy should be based on the number of options in each grant, the exercise price of each grant, and the tax outcome of exercising each grant. While having multiple grants with different exercise prices certainly complicates things, it also presents you with opportunities to pursue multiple ISO exercise strategies with your different grants.
Another thing to note is just because you choose a specific ISO exercise strategy for one of your stock option grants, it doesn’t set that choice in stone. Wanting to change strategies is perfectly okay — and to be expected. Pivoting is a natural response to your situation changing. That’s especially the case once your company transitions from pre- to post-IPO, where you’ll deal with a stock price that changes every day. As you continue to gather more information and your situation evolves, expect yourself to want to adjust your strategy.
Find the best ISO exercise strategy for you
Remember, there’s no one-size-fits all ISO exercise strategy, so choose the type of strategy that best suits your unique situation.
You have an entire menu of methods you can employ. Regardless of which strategy you choose, you can avoid tax mishaps by staying organized, keeping records of everything, paying attention to the details, and avoiding taking action before understanding the consequences.
Need a helping hand? Book a call today to talk to myself or another expert on our team about the best ISO exercise strategy for you.
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