Financial Advisor Insights

Tax Planning Strategies for Incentive Stock Options (ISOs)

Develop a tax planning strategy before exercising your ISOs. Commonly referred to as equity-based compensation, the term “stock options” can mean an individual is given equity – or given the option to buy equity – in a number of different ways. Several tax planning strategies for incentive stock options exist, but if only considered post-exercise, these tactics lose much of their effectiveness.

Incentive stock options (ISOs) are one way for employees to receive equity, although many employers are now shifting to the simpler restricted stock unit (RSU) model. ISOs allow employees to buy a specific number of the company’s shares at a fixed price, the strike price, which is often equal to the market value at the time the options are granted. The tax implications of exercising ISOs will vary depending on how the options are managed; before exercising your options, it is very important to learn about tax planning strategies for incentive stock options.

Incentive stock options have unique tax benefits as opposed to other equity-based compensation methods, such non-qualified stock options or restricted stock units. Unlike other types of stock options, with ISOs, there is no tax due upon exercise. Further, if an employee meets certain holding requirements, the stock will only be taxed at favorable long-term capital gains rates when the stock is sold. But be aware - choosing to hold onto the stock for long enough to receive this favorable tax treatment does not come without a cost – it may trigger the Alternative Minimum Tax (AMT).

Favorable Tax Treatment for ISOs

A qualifying distribution occurs when an individual holds the shares for at least two years after the grant date and at least one year after the exercise date. After this period, when the stock is subsequently sold, the employee will pay long-term capital gains on the gain. The gain is the sale price less the grant price multiplied by the number of shares sold.

Best practices for stock optionsDisqualifying Distributions 

ISOs will not be eligible for favorable tax treatment when a disqualifying disposition occurs. When a stock option is sold within two years after being granted, or within one year after being exercised, ISOs lose their favorable tax treatment. In either of these scenarios, the individual will need to report at least part of the transaction as regular income. The portion that will be taxed at more favorable capital gains rates will depend on your holding period and whether the market price of the stock at the date of sale is higher than the market price at the exercise date. If the stock is sold at a loss, the individual will typically only pay regular income taxes.

Employers Don’t Withhold Taxes on ISOs

Regardless of the ISO holding period, an employer will not withhold any funds or remit tax payments on behalf of the employee. Therefore, when considering investment options for the sale proceeds, it is very important to remember that you may owe a substantial amount in taxes in the current year. This can be especially important during a disqualified distribution, as an individual will likely owe both taxes on regular income as well as capital gains. Working with a CPA to estimate your tax liability is recommended.

How Can Exercising ISOs Lead to AMT Issues?

One major drawback to incentive stock options is the potential that they may trigger the alternative minimum tax (AMT). The AMT is fairly complex, but at a high level, it is a parallel tax calculation which disallows – or adds back – certain tax deductions and non-taxable items that individuals may be permitted to use when calculating their tax liability under the regular system. Instead, in the AMT calculation, filers are allowed one exemption amount, which is phased out with income. Taxpayers will ultimately pay whichever number is higher; their tax liability under AMT or their regular tax liability.

Taxpayers who exercise and retain their ISOs during a calendar year may have AMT concerns, as a part of this transaction must be reported as income for the AMT calculation. The difference between the price paid for the stock and the fair market value of the stock upon exercise is called the bargain element. The bargain element must be reported to the IRS for alternative minimum tax purposes in the same year that the stock options are exercised, unless they are sold during that year. This (sometimes drastic) increase in phantom unrealized income can leave some individuals owing thousands of dollars more in taxes than they may have anticipated.

ISOs and the AMT: Ways to Reduce the Impact on Your Tax Situation

Although there isn’t always much to be done about an AMT liability, with proper planning there are ways to help offset the impact of ISO exercises on AMT.

  • Estimate the impact – before exercising incentive stock options available to you, work with a tax professional to calculate the projected impact for AMT. Based on this information, you may want to refrain from exercising all of your options at once, or sell a portion during the year. The stock sold will not be included in the AMT calculation and can also help fund an existing AMT liability. To try and avoid AMT altogether, calculate the amount of options you can exercise in the year without your AMT exceeding regular tax due.
  • Monitor the stock price – it can be advantageous to exercise ISOs in the beginning of the year; then, if stock prices decline from the fair market value (FMV) at time of exercise, consider selling the stock. Although this strategy will create a disqualifying disposition, it will also avoid becoming an AMT preference item. By holding onto the stock an individual may be forced to pay AMT on a phantom gain, as the bargain element is calculated based on the FMV at exercise, not current market prices.
Tax Planning for ISOs

Other Considerations

As you consider the role stock options play in your overall compensation package, keep in mind a couple of key points:

  • Diversification – many individuals opt to sell their ISOs upon grant in order to limit a potential downside and diversify their assets. As an employee, much of your financial stability is likely dependent on your salary and the continued operations of your employer. Consider cashing out a portion of stock compensation and investing in more diversified funds across the market.
  • Stability of stock price –as with any investment, ISOs carry risk. Unstable stock prices may prevent from you from exercising at all if the stock price never rises above the grant price. Even worse, should the stock plummet after exercise, it could even end up in a loss.
  • Review your options – before exercising ISOs, do your homework and find out what options may be available. Some companies may offer a cashless exercise – which absorbs some of your stock options to cover transaction costs in case you don’t have the funds to go out of pocket. This can also be a good strategy if you’re concerned about stock price volatility but do not want to delay exercising your shares.

Stock options can be quite complex. If you have ISOs or other stock options, it is very important to consult your financial advisor and tax professional to determine a strategic plan for your stock options before exercising. Although there is a lot of credible general guidance out there, the optimal course of action will be very specific to your personal situation. Your vesting schedule, company stock projections, available cash on hand, and overall tax situation are just a few of the drivers influencing how and when to exercise stock options.

Managing stock options can be quite complex. As an independent fee-only financial advisor, we partner with clients to help navigate complex financial planning situations. 

Wealth Management Financial Planning Advisor

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