Sometimes, stock prices fall.
Yes, even after you exercised them at the beginning of the year with 100% confidence that the price would go up and you’d make a lot of money. ????
So when your investment plan with your stock options is going to poo ⬇️ ????, what do you do?
When you exercised your stock options in January, you fully expected the market value to go up. Then, you were going to hold them for a year or more before you sold.
Once sold, you’d get a serious influx of cash, and be able to be taxed at a lower rate. (Long-term capital gains tax is lower than regular income tax on shares held less than a year.)
So let’s say you exercised in January 2019. You’d have expected to trigger the Alternative Minimum Tax (AMT) when you exercised, but you weren’t worried. You knew that as long as the stock went up (which you felt was bound to happen), you could sell one year later in February 2020, have cash to pay your AMT in April 2020, and then get a Minimum Tax Credit (MTC) when you filed your 2020 taxes in April 2021.
But here’s the thing about IPOs:
They don’t always go so well. And a lot of times, prices unexpectedly go down. Sometimes, you’ll find yourself selling ISO exercised in January before you reach that one-year mark.
IPOs Don’t Always Go So Well
In fact, if you don’t have access to stock options within a company to buy shares at a lower price, newly-IPO’ed stocks can make terrible investments.
These new stocks are showcased first to a limited group of investors, and they’re marketed to this group based on what the company could become, not based on what the company is doing today. (Which drives the perceived value up.)
Then when the lock up period expires, they’re available for everyone to buy.
After the lock up, there are usually more sellers (employees and private investors) than buyers. This drops the price of the stock, and puts people like you into the situation you’re in now.
Because these stocks are often small market cap growth stocks, it means they’re small and over-priced.
There are exceptions, of course, like Anaplan’s IPO in 2018, and Zoom’s IPO in 2019. Both stocks have risen steadily in value, making their investors money.
But the list of IPO stocks that have decreased in value is really, really long:
- Dropbox (DBX)
- $21 = 2018 IPO price
- $20.67 = Jan 2, 2019 price
- $17.76 = Aug 23, 2019 price
- Eventbrite (EB)
- $23 = 2018 IPO price
- $27.80 = Jan 2, 2019 price (Yay, going up!)
- $18.34 = Aug 23, 2019 price (Oh wait… crap!)
- Lyft (LYFT)
- $72 = 2019 IPO price
- $49.11 = Aug 23, 2019 price
- Uber (UBER)
- $45 = 2019 IPO price
- $33.42 = Aug 23, 2019 price
This is why it’s important to be careful about exercising your stock options too much leading up to an IPO. The internal workings of the company really don’t matter once the stock price goes public. All that matters is what millions of investors judge your company to be worth from the outside. (And, since they can’t see the inside of the company, it usually isn’t a fair judgement.)
What to Do if You Exercised & Held ISO This Year
Let’s say things were looking good for your company, so you decided to exercise ISO in January. You were sure the price would go up and you’d be in a great position to sell in February 2020.
But now… the stock price is lower than it was in January, and you think it’ll keep going down even more. Since your company will be reporting their Q3 earnings soon, you’ll have one last trading window to sell your stock in before 2019 ends.
So do you cut your losses and start selling ISO exercised in January before things get worse?
Or do you hold the shares, hoping things will turn around at some point in the future?
If you sell the shares you got via ISO (incentive stock options) now, you’ll disqualify the ISO, and four things happen:
- The market value share price when you exercised doesn’t matter anymore.
- Any AMT you may have triggered by exercising these options goes away.
- Your tax bill will be based on the lower share price, not the higher one when you exercised.
- Your gains are taxed as ordinary income.
For example, one of our clients exercised his ISO at a $6 exercise price in March, when the public price of the stock was trading at $20 per share.
His plan was to hold for one year, and then sell so he’d be taxed at the lower rate for long-term capital gains (LTCG). He’d use some of the cash he got from selling to pay the $170,000 AMT triggered by the exercise. (A rough calculation based on $20 – $6 = $14, multiplied by 28% equals $3.92 in AMT per stock.)
But the price didn’t go up, it went down. In August, it reached the $16 mark.
If he sells now the AMT he owes goes away. Instead, since he’s in the 37% tax bracket, we’d estimate his tax bill according to ordinary income tax. $16 – $6 = $10, multiplied by 37%, equals $3.70 per stock owed, instead of the $3.92 from the AMT scenario above.
Selling ISO Exercised In January: Why You Should Sell Now
It sucks when things don’t go according to plan, but if you like the price of the stock right now, go ahead and sell. Remember, price and the money you get back is the most important aspect here. You can always figure out taxes after you decide how you feel about the return on the money you’ve already put in.
If you don’t go ahead and sell, you’re putting your finances into the hands of what the price of the stock might do later. We can’t predict the future, so it’s better to be safe than sorry.
And when you’re deciding whether or not to sell now… make sure selling will also guarantee that you’ll owe less per share than if you hold.
For example, the client we talked about above saved $0.22 per share, which added up to a significant amount of money with all of his shares. Plus, he’s able to get his cash infusion now, instead of waiting until later. (Versus if you hold the stock, you still have to pay the AMT, even if you don’t get the cash infusion to cover it. PLUS, on top of paying the AMT, you’ll also have to pay future taxes on the long-term capital gains you get when you do sell.)
Why You Should Hold & Not Sell Now
Selling ISO exercised in January isn’t a good idea if these shares are a part of your long-term investment plan. If they’re part of what you consider your long-term investment portfolio, then hold them, or hold onto some of them. (I like to tell clients to hold about 20% of their total equity in the company as a long-term investment.)
So if you see these stocks as a long-term play, then don’t let what could just be a few-years-long price dip get in your way. Stick to your plan.
Why Tax Calculations & Projections Are So Important
As you saw in the example above, one of our clients realized he could save $0.22 per share if he sold now instead of following through with his original plan to hold and sell after a year.
If you decide to sell now, you’ll be done with your taxes on them the next time you file. You’ll pay how much you owe on their sale, and that’s it. You don’t have to pay the AMT, and once you’ve paid the ordinary income tax, you’ve paid it. It’s pretty simple.
But if you decide to hold, the tax ramifications could play out over three years or more. In the first year, you’ll have to pay your AMT. In the second year, when you’ll sell, you’ll owe tax on long-term capital gains, and you may get some MTC to use against the rest of your tax bill. And even after that, you may have MTC that carries over into years to come.
A Precise Tax Calculation on Selling ISO Exercised in January Makes All the Difference
There are a lot of variables, especially since nothing about the plan to hold onto your ISO as a long-term capital gains investment is simple. Beyond the AMT and MTC calculations, you’ve got things like RSU, changing jobs or getting promotions, and SO MANY other things that could affect your tax bill in the years to come.
This is why it’s best to work with someone who’s done the math on these kinds of situations more times than they’ve tied their shoes. A precise tax calculation here will help you make the best decision on whether or not to sell ISO exercised in January.
To book a discovery call with one of our ISO tax experts, click the button below and book a time.
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