Exercising Incentive Stock Options in January can provide flexibility and benefits unavailable a few months later.

Well, with Incentive Stock Options, there really isn’t any good blanket advice for everyone. There are too many factors related to your household income, tax situation, risk tolerance, company stage, etc. for any one piece of advice to apply to everyone. So the title should be:

If you have vested, unexercised Incentive Stock Options in a publicly traded company that you are planning to exercise this year, you should probably exercise your ISOs in January.

But that doesn’t quite grab your attention the same way. And unfortunately, that’s how the world works these days. The simple bold statement gets the attention, but the truth is full of nuance and caveats. And that’s what this article is; the caveats and nuance to help you understand why exercising in January might make sense for you.

You need to exercise and hold ISOs for one year before selling for the spread to be taxed as Long-Term Capital Gains instead of Ordinary Income

This is the main difference between ISOs and NSOs (Non-Statutory or Non-Qualified Stock Options). With ISOs you have the flexibility to take on some investment risk to get a better tax benefit. You can always choose to exercise and immediately sell your ISOs sooner. This is called a disqualifying disposition and your ISOs would have the same tax treatment as NSOs.

Another benefit of ISOs is that exercising NSOs is a taxable event, regardless of whether you sell the stock, but exercising ISOs is not subject to Social Security, Medicare, or withholding taxes.

With ISOs, it always comes back to AMT…

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 (and holding for one year) is one common way taxpayers are pushed into AMT.

NSO exercises are taxed as ordinary income and do not affect the AMT calculation.
Exercising ISOs, but disposing before the twelve-month holding period, means they will be taxed like NSOs, at ordinary income rates.
- “Disposing” is usually selling, but could also include gifting, exchanging, or transferring.
Therefore, selling ISO shares before being held for one year, intentionally creating a disqualifying disposition, removes any AMT concern from the original ISO exercise.

Exercising in January gives you the most time to maintain this flexibility in the same calendar year. You have more time to decide if you want to maintain the ISO status or sell early as a disqualifying disposition, without paying AMT.

If the stock price goes up after exercising, everything works out well. You might be subject to AMT on the lower amount, then get to sell at the higher amount and pay long-term capital gains rates on all the growth. You have a big tax bill and you are all the happier for it.

But if the stock price drops after you exercise, while you are holding for one year…

This is where you want to create the disqualifying disposition in the same year as exercise. A VERY rough rule of thumb would be that if the stock price drops by more than 30% after exercising, you may be better off selling and paying ordinary income taxes (on the difference between sales price and exercise price) than paying AMT (on the difference between FMV at exercise and exercise price). This is dependent on many other factors regarding your household income and tax situation, so you will need to do the math (or consult a CPA or financial advisor), to find what that break-even point is. The important point is that by exercising in January, you have created the opportunity to potentially save money in taxes if the stock drops after exercising.

If you wait until the following calendar year, after you may already have paid the AMT for the exercise, the disqualifying disposition may not make as much sense. You might still be better off waiting out the one year holding period to get long-term capital gains rates.

Exercising ISOs in January gives you the most time to satisfy the twelve month holding period while maintaining the possibility of getting out of AMT is the stock price drops after exercising.

What about AMT Credits?

So far I have ignored AMT Credits, mostly because they are too individualized to plan out, but you should at least be aware of the possibility of receiving those credits.

Each year, when calculating taxes, there are two separate tax calculations. The regular calculation and the AMT calculation. You pay the higher of the two calculations. If you are in AMT, which happens to those exercising significant ISOs, the actual Alternative Minimum Tax is the difference between the AMT calculation and the regular calculation. This is also the amount that may be credited in the future.

If you pay AMT one year, but are not in AMT in a future year, you can receive a credit for the AMT paid against your regular tax in that future year. BUT, you can only apply that AMT Credit to the amount that your regular tax calculation exceeds your AMT calculation in that future year. If your AMT calculation is close to the regular calculation in future years, it’s possible you may not get to use that AMT Credit or that it may take many, years moving forward to eventually get it back.

This example uses salary of $300k and exercising and holding ISOs with $1M gross value and $100k exercise cost. (Bargain element = $900k) Stock is sold in Year 2, generating Long-Term Capital Gains. No change in salary or stock price from Year 1 to Year 2.

For the remainder of this conversation I will not be considering future AMT Credits, but when you are estimating future taxes and planning out an ISO exercise and hold strategy, it is important to factor in the potential benefit of these credits.

I still owe a large tax bill due to AMT and I haven’t sold the stock. How do I pay that first tax bill?

This is the next stage of why you want to exercise in January.

Depending on your prior year’s income, your withholdings from your salary, the state you live in, etc. when you exercise the ISOs this year, you may not need to withhold anything. The high tax bill due to the AMT on your ISO exercise is due the following spring.

You can sell the ISO shares the following January, satisfying the twelve-month holding period, establishing Long-Term Capital Gains, and get the proceeds before the large tax bill is due.

This window only exists for the couple months at the beginning of the year before you file your taxes. You are exercising in January to be able to sell the following January/February before your taxes are due.

Consult your CPA regarding withholdings or estimated payments.

One important caveat that may apply to more people is to be aware of withholding requirements and estimated quarterly payments. Please consult a CPA to determine how much you should be withholding and whether your actions may require estimated quarterly payments. A few rules related to avoiding a withholding penalty include:

For Federal taxes, you need to withhold the lesser of 110% of you prior year’s income tax OR 90% of this year’s tax.
If this is your first year exercising ISOs or selling company stock, you can probably adjust your withholding on your regular pay check to satisfy this requirement.
- If you usually get a tax refund and your regular salary hasn’t changed, you may already be withholding enough to cover 110% of last year’s tax, but it is important to double check.
For California taxes, they follow the Federal withholding rules, unless your income is over $1,000,000. Then you may need to withhold or pre-pay 90% of the tax. The option to withhold 110% of the prior year’s tax is not available for incomes over one million.

Use proceeds to fund next year’s exercise

Ok, everything has worked out perfectly. You exercised in January, checked with your CPA that your withholding on your pay check is sufficient, held the shares for twelve months, sold the following year, and used the proceeds to pay the tax bill.

When most companies grant stock options, there usually include vesting schedules and ten year expirations. After exercising your ISOs in January, you may have had more ISOs vest throughout the year. By selling the following January, in addition to covering the AMT bill from exercising, you can use the proceeds to pay for the exercise of the next tranche of vested ISOs. This helps the concentration risk that can arise from significant ISO grants by selling the same stock you are using to exercise the options in that stock. You do not need to use cash or outside investments to pay the exercise price.

Other factors to consider…

It’s OK to exercise and sell. You do not need to hold the shares.

By exercising and holding, you are taking on additional investment risk. You also need to come up with the cash for the first exercise cost. Most clients I help are not exercising and holding everything or selling everything immediately. Most people are in that gray area in the middle. For some we determine how many shares to sell immediately to cover the exercise cost for all the shares. For others we sell more to reduce the investment risk, but hold on to some shares at a level they are more comfortable with.

Be mindful of trading windows and blackout periods.

Most companies restrict when employees can sell shares of company stock. You likely won’t be able to sell shares before quarterly earnings reports, but the size of the trading window is different from company to company. You may not actually be able to sell shares until February or March depending on when your company announces their earnings. You can probably still sell before the April 15th deadline, but it can get pretty close if you’re not careful.

Coordinate with other equity compensation

Restricted Stock Units are taxed as W-2 income as they vest. This can increase your regular taxable income and increase your exposure to your company stock. The taxes are based on the vesting dates determined in the grant documents. You do not have control of this, so you need to make sure to plan around it.

NSOs and Stock Appreciation Rights (SARs) can increase your ordinary income and regular tax calculation, but you have control of the timing of these tax events. It may be possible to strategically exercise these grants to increase your regular tax calculation, possibly reducing or eliminating AMT.

Be careful of the wash-sale rule, especially with ISOs!

If you sell your ISO shares in a disqualifying disposition, then repurchase the same stock within 30 days, the loss can be disallowed. With ISOs, this can mean that you are still liable for the AMT based on the original exercise.

Automatic purchases via an Employee Stock Purchase Plan (ESPP) and exercising stock options within 30 days of selling ISO shares below the Fair Market Value at exercise can result in an undue tax burden.

Private Companies and IPOs

Most publicly traded companies do not issue Incentive Stock Options. They are more likely to issue Restricted Stock Units (RSUs), NSOs, or Stock Appreciation Rights (SARs). ISOs are more likely to be granted by private companies.

If you were granted ISOs at a private company that has recently had an Initial Public Offering (IPO), you may be subject to additional restrictions on when you can exercise or sell ISOs. This will require additional coordination of timing regarding when and how many ISOs to exercise or sell in which calendar year.

If you work at a private company and there is not an IPO on the horizon, exercising ISOs has an even greater investment risk. In addition to the possibility that the shares are never able to be sold, you are not putting your own money at risk when paying the exercise cost. At least when the company is public, you can sell some shares to cover the exercise cost. Or have a reasonable expectation that you will be able to sell shares to make up for the money you spent on the exercise.

If you are confident you want to take on the investment risk of a private company and you can afford the exercise cost, it may be possible to exercise some ISOs without triggering AMT. This will require coordination with a CPA and calculating both the regular tax and the AMT. The difference between these two calculations can indicate how much of the ISO bargain element can be realized before the AMT calculation is greater than the regular calculation. It may make more sense to do this calculation at the end of the year when you have more information on what your regular income tax for the year will be.

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