Now that you have a good estimate of your income for the year, you can calculate how many ISOs to exercise without going in to AMT.
Photo by Behnam Norouzi on Unsplash
Wait. Aaron also said that I should exercise my ISOs in January. What gives?
This gets back to the idea that there is no good blanket advice for everyone when it comes to Incentive Stock Options. If you have ISOs in a publicly traded company, it probably makes more sense to exercise in January. But…
If you have vested, unexercised Incentive Stock Options in a PRIVATE (pre-IPO) company and it is unlikely you will be able to sell the shares next year, you should probably exercise some ISOs in December.
The primary tactic is that you may be able to exercise some of your ISOs without incurring the Alternative Minimum Tax for this calendar year.
Under the regular tax calculation, exercising ISOs is not a taxable event, but the spread between exercise price and Fair Market Value at exercise (bargain element) is added to the calculation of your Alternative Minimum Tax.
For most people, their regular income tax calculation is usually higher than their AMT calculation. Exercising ISOs is one common way taxpayers are pushed into AMT.
To calculate how many ISOs you can exercise without going in to AMT:
Start with a good estimate of your taxes for the year, including all income, deductions, etc.
A CPA or tax-preparer (or yourself using TurboTax) can increase the Exercise of Incentive Stock Options (IRS Form 6251, Part I, Line 2i) until the tentative minimum tax (Form 2651, Part II, Line 9) is just a little less than the regular tax calculation from your 1040 and before the AMT on Line 11 gets above 0.
You now know how much ISO bargain element you can realize without incurring AMT. The bargain element (or spread) is the difference between the Fair Market Value (FMV) at the time of exercise and the exercise (or strike) price.
For pre-IPO companies, the Fair Market Value is most likely the current 409a valuation. You can ask the CFO or stock team for this information.
(FMV @ Exercise - strike price) x numbers of ISOs exercised = Alternative Minimum Taxable Income from Exercise of incentive stock options.
You can divide the total ISO bargain element from Line 2i by the current spread between 409a and your exercise price to find out how many options you can exercise without incurring AMT for that calendar year.
You may feel comfortable risking the money it costs to exercise ISOs, but not the exercise cost PLUS any AMT.
When you exercise ISOs, this is not a taxable event under the regular (1040) tax calculation. Unlike Non-Qualified (Non-Statutory) Stock Options (NQSOs or NSOs) and Restricted Stock Units (RSUs), there are no taxes withheld when you exercise ISOs. If you can avoid any AMT, this means the only cost out of pocket is the exercise cost per share times the number of options exercised.
At this stage of the company, you need to be prepared to lose any money you put towards exercising options. This is an extremely high risk investment. Even later stage private companies may not have an IPO. There is no guarantee that your class of stock will get paid out in a liquidity event such as an acquisition.
The exercise cost and ‘manageable expense’ are different for every person. With private companies, the exercise cost per share tends to be low enough that it isn’t a prohibitive factor.
I want to emphasize again that you need to be ready to completely lose any money you spend exercising these options. If you are not comfortable with this risk, it really is ok to hold on to the options and wait and see if the company eventually goes public. You will still participate in all the upside by holding on to the options.
If I can still participate in the upside without exercising ISOs and putting money at risk, why should I exercise now?
You can sell at Long-Term Capital Gains rates as soon as possible.
If you exercise ISOs and hold the shares for more than one year before selling, the entire gain from exercise price to sales price will be taxed at preferential Long-Term Capital Gains rates. In this situation, where it is unlikely you will be able to sell the shares in the next year anyways, satisfying the twelve month holding period doesn’t seem like a constraint.
When/if an IPO happens and you can sell shares, you will already have some ISO shares that you can sell as soon as possible that qualify for Long-Term Capital Gains rates. If you wait until the IPO event to exercise, you will need to wait another year after that to qualify for Long-Term Capital Gains tax rates.
Having some exercised ISO shares helps mitigate a “golden handcuffs” situation.
ISOs are only available for employees. If you leave the company, you lose either lose the ISO status or you lose the options completely.
Some companies allow you to keep the options for up to three years or the expiration date of the option, but not all companies. This is a company specific stock plan. Many companies require you to exercise ISOs within 90 days of leaving the company or you lose them.
Even if you can keep the options based on the company plan, they would be treated as NSOs, not ISOs.
Exercised shares you keep. Unexercised ISOs you may lose.
If you wait until you are leaving the company before exercising any ISOs, there is a realistic risk that the total spread/bargain element between exercise price and Fair Market Value has increased enough that the AMT bill can become prohibitive.
Exercising all of your ISOs at once can incur an AMT bill on the scale of hundreds of thousands of dollars if the stock value has increased substantially.
The “golden handcuffs” happens when the ISOs have significant value, but you can’t sell them yet. If you leave the company, while the exercise cost may not be significant, the AMT will be, and you may not have the liquidity to cover the tax bill.
Even if you did have enough liquidity to cover a significant AMT bill, the investment risk of a pre-IPO company is still extremely high and putting that much money at such a high risk may not be the best use of your capital. The money you would have spent on AMT you can leave invested and growing elsewhere.
Why pre-IPO companies? Couldn’t I do this for public companies?
The main difference is that you can’t choose to sell the shares even if you wanted to.
For publicly traded stock, you can choose to sell these shares in a “disqualifying disposition” so that they are taxed as NSOs. There is usually some combination of selling ISOs immediately and exercising and holding others that creates enough liquidity to cover the AMT bill for the ISOs that are exercised and held.
However, with ISOs in private companies, there usually isn’t an opportunity to sell the shares, either to reduce AMT or to raise enough cash to cover the AMT bill.
Why December?
Mostly just because this is the time of year that you have the information to be able to project your tax situation accurately. You know what bonuses you or your spouse received earlier in the year. But if you have a reliable prediction of your taxable income for the year, you could use this strategy earlier in the year.
One example of using this strategy earlier in the year is if you think the 409a valuation will be going up soon. Please do not act on inside information. A couple of my clients were able to guess the 409a valuation would be going up based on rumors of a new fundraising round, but they freely admit this was just a guess and they got lucky in timing.
Exercising ISOs before an increase in the 409a valuation allows you to exercise more ISOs without increasing the total bargain element in the AMT calculation.
Your taxable income won’t change based on the stock price increase. But the spread between FMV at exercise and your exercise cost will increase (increasing the denominator of our calculation above), meaning you need to exercise fewer ISOs to stay under AMT.
Incentive Stock Options can provide greater benefits and flexibility than other forms of equity compensation, but they are complex.
Consult your CPA or Financial Advisor!
If you have any questions, please feel free to email me at aaron.agte@graystoneadvisor.com or schedule a meeting.
Aaron Agte, CFP®, founder of Graystone Advisor, is a fee-only Financial Planner located in Foster City, CA, serving clients virtually in the Bay Area and across the country. He specializes in helping couples with stock options, RSUs, and other equity compensation.
@AaronAgteCFP