The purpose of incentive stock options (ISOs) are to provide incentives to attract, retain and motivate people whose contributions are important to the success of the company by offering them an opportunity to participate in the company’s future performance through the grant of awards. Typically, we see ISOs granted by private companies, and as those companies go public, they generally replace their ISO equity to an RSU equity offering. ISOs have created tremendous wealth to those who have been fortunate enough to align with a company who has experienced significant growth in valuation, but with that wealth comes a lot of strategies on the best way to manage your ISOs and company equity.
The first thing to understand about your ISO grant is that it is not taxable upon grant or vesting, which differs from other types of equity compensation such as RSUs or NQSOs. This is particularly attractive in a startup company that doesn’t have a liquid market to redeem shares to cash to cover taxes. In many instances, these startup companies offer larger ISO grants because they don’t have the cash to pay bigger salaries and cash bonuses early on.
That is about where the simplicity of ISOs ends, as they are one of the most complex forms of equity grants, primarily due to the fact that ISOs are one of the few things that can trigger the alternative minimum tax (AMT). The AMT operates alongside the regular income tax. It requires some taxpayers to calculate their liability twice—once under the rules for the regular income tax and once under the AMT rules—and then pay the higher amount. The AMT is complex and could cause you to actually owe tax even though you never sold your stock!
Before we get into our 3 keys to optimize your incentive stock options, I want to outline a few key terms we will use throughout this article:
- Grant Date: The date you are granted your ISO
- Vesting Date: The date your ISO vests and you officially own the option to buy stock
- Exercise: When you turn your option into a share of stock
- Strike Price: The price you can purchase 1 share of stock for based on your option
- FMV: The fair market value of the stock (publicly traded price or 409A valuation for private company)
From a taxation perspective, if you hold your option for 2 years after the grant date and 1 year after your exercise (qualifying disposition), then the gain (FMV minus exercise price paid) is taxed at long-term capital gains, which is a preferential tax rate (0%, 15%, 20% depending on your total income) and more favorable than ordinary income rates (up to 37% currently). If you exercise your option and then proceed to sell the stock and you do not meet the 2-year holding period from grant date and 1 year from exercise (disqualifying disposition), the gain will result in compensation income and must be reported in Box 1 of Form W-2, but such wages are not reportable as FICA wages nor subject to FICA tax. FICA taxes are divided into two parts: Social Security tax and Medicare tax. The Social Security tax rate is 6.2% of wages for 2020, and the Medicare tax rate is 1.45% of wages. Together, these make up a tax rate of 7.65% for FICA taxes on top of your income tax.
If you exercise your option and sell in the same tax year (disqualifying disposition), you do not need to worry about the Alternative Minimum Tax (AMT), but if you exercise your option and do not sell it in the current tax year, you could be subject to AMT. For many, this comes as a surprise and in some cases could put you in an unfavorable position as you had to come up with cash out-of-pocket to buy the stock (exercise price) and now a potentially large AMT tax bill.
With all of that being said, this is something you should not try and navigate without the help of a tax & financial expert that can assess an exercise and disposition strategy to fit into your overall financial plan. Incentive stock is one of the most common reasons our clients hire us. In many cases the value of their incentive stock can be 50%-90% of their net worth and one wrong decision could be extremely costly.
3 keys in how we help optimize their incentive stock options:
1. Begin the exercise process as early as possible, even if you can only afford minimal amounts.
This is one of the biggest mistakes we see people make. Many clients have come to us because they received ISO grants upon joining their company as well as refresher grants each year thereafter, but they did not do anything with those options. Now they are approaching a liquidity event such as an IPO or a tender offer and they are facing ordinary income tax instead of preferentially taxed capital gains upon a disposition. This could mean the difference of a 37% tax rate (top Federal income tax rate) vs. 23.8% tax rate (top long-term capital gain tax + 3.8% Net Investment Income Tax).
In addition, many times the company valuation is much greater now that it was when the employee was originally granted the option. For example, I have a client who received 100,000 options in a private company in Silicon Valley 7 years ago with a strike price of $0.26 as well as a base salary of $250,000. The options vested over a 4-year period and the company had a valuation of $1.70 per share at the time of the grant. This client had 3 options available to him:
- Do nothing, which will kick the tax liability down the road to a future date in which the employee may exercise and potentially sell stock. At that future date the stock’s FMV could be substantially higher, which would create a substantial amount of AMTI (alternative minimum taxable income) upon exercise or a substantial amount of ordinary income tax upon exercise and sale (in the same tax year).
- Exercise as much as possible. In some cases, the employee might have the ability to exercise all of their options immediately, even if they are not vested. This brings a risk to the employee in that if they leave the company, they will forfeit the unvested stock, but they would have paid to exercise the options as well as paid the AMT, which they will not recoup. This is a gamble in which you could substantially win if the FMV appreciates substantially and the employee stays at the company through vesting. It would put you in a position where you would have minimized your AMT and maximized your capital gain income upon a qualifying disposition.
- Find a middle-ground and exercise some of your options. This is the one most people miss, but the reality is that it is usually the best option for people if they cannot afford a big upfront AMT tax bill or the out-of-pocket cost of exercising all their options. There is actually a threshold that most people can take advantage of to exercise some of their stock options without triggering any AMT. We call this your option exercise sweet spot because you will convert the options to shares, which will start the clock on a qualifying disposition to make you eligible for capital gains tax vs. ordinary income tax, and you will not be hit with any AMT. In this case your only out-of-pocket expense is the cost to exercise, and if you feel confident the value of the company will increase, this is a good investment.
Let’s see how these three options could have played out for my client. The company IPO’d in 2020 and the stock is now trading at $250/share. He now has a pre-tax net worth of $25,000,000 and a cost to exercise (strike price) of $26,000.
With option 1, he could exercise everything and then sell this year and have $24,974,000 ($25,000,000 minus $26,000 exercise cost) of ordinary income taxed into the highest marginal rate of 37%. That would give him an income tax bill of $9,423,186.
With option 2, he would have had AMTI of $1.44/share which would have caused AMT of approximately $30,000 as well as the out-of-pocket investment of $26,000 to exercise, and today would have $24,974,000 in long-term capital gains upon selling. This would leave him with a tax bill of $5,908,811. That is $56,000 to save over $3,500,000 in taxes! In addition, that $30,000 in AMT will actually carry-forward to a minimum tax credit in future years.
With option 3, he would have ended up somewhere between option 1 and option 2 by exercising along the way.
2. Ensure your exercise and disposition strategy is coordinated with your short-term, intermediate-term, and long-term financial goals and objectives.
As you accumulate more and more highly concentrated wealth through your company equity either through additional grants or increased company valuation, a documented and coordinated exercise and disposition strategy becomes essential. At some point you need to start thinking about de-risking your holdings by diversifying. There are countless stories of the famed dotcom era where fortunes were made and lost because employees were anchored to their company equity without de-risking through diversification. I always like to start this planning by compartmentalizing your financial goals and objectives into three buckets: Now, Soon, and Later. For some, you may need to turn your company stock options into cash immediately to supplement your living expenses or for a large purchase such as a home down payment. If this is the case, the timing, execution, and selection of which options to dispose of can become very important to analyze.
In other cases, you might not need the money for anything immediately, but you want to begin to de-risk from your highly concentrated positions and do so in a meaningful way by spreading the tax out over several years. This disposition strategy would potentially encompass both your Now and Soon Buckets. It is critical to not only look at your company stock and options, but the investment strategy of your other assets because utilizing tax-efficient and tax-managed investment portfolios could actually offset some of the tax from disposing of your company stock. Many times, I see people invest their non-company stock holdings in things like index funds, actively managed mutual funds or bonds and these investments could produce unnecessary income which ultimately impacts the tax of your disposition plan.
Lastly, some of you might be in it for the long-term, particularly if you are a founder or plan to stay with the company for a long time. In this case, the stock and options would sit out in your later bucket, but we recommend creating a target percentage of your net worth you are comfortable with having concentrated in the company stock. Highly concentrated positions can give you the opportunity to be very rich, while a prudently diversified strategy can provide you the peace of mind that you will not be poor. For some of our clients, they were in the right place at the right time to earn these equity grants and they have enough money to last them and their family a lifetime. They aren’t as worried about the potential of that stock doubling or tripling again, but their focus is on stability with reasonable growth while reducing risk. For others, they are willing to accept the risks to attempt to achieve a much greater reward.
For many of our clients, once they have achieved success financially, they turn their attention to philanthropic initiatives. For these clients, their charitable giving should coincide hand-in-hand with their stock disposition strategy. Depending on the level of giving, strategic contributions into a donor advised fund could offset a huge portion of the tax liability to diversify a portion of your holdings. While you cannot contribute ISOs directly into a donor advised fund, you need to analyze whether it makes sense to exercise and sell (disqualifying disposition) and use the cash to fund your donor advised fund or whether it makes sense to contribute already exercised shares to circumvent the long-term capital gain of that appreciated stock as well as receive the charitable deduction.
Charitable contribution deductions are currently limited to 60% of your AGI for cash and 30% for appreciated capital gain assets. In many cases, we optimize a blend of both disqualifying disposition stock as well as qualifying disposition stock into a charitable plan with our clients to maximize their funding levels and minimize the tax due. For other clients who wish to contribute a substantial amount to philanthropic efforts in addition to maintaining more control of their giving, a family foundation could be an additional option. This creates much more expense and responsibility around governance but could be an appropriate solution for high net worth clients who want to dedicate a portion of their time to philanthropy. Lastly, certain charitable trusts such as charitable remainder trusts and charitable lead trusts could also be used to support your charitable intent.
3. Understand how your ISOs could be impacted if/when your company goes public (IPO)
At some point the time comes for a successful private company to go public. This can be an extremely exciting time for you as an employee with ISOs and company stock, but it can also bring a lot of uncertainty in thinking through your personal financial decisions. Generally, when a company is getting ready to IPO, they stop issuing new ISOs and switch to providing their employees with RSUs (see article on RSUs). If you do get a RSU grant, the vesting needs to be accounted for in your exercise strategy of your ISOs, and ultimately disposition strategy of your stock. When your RSU vests, it is taxed as ordinary income and if you haven’t adjusted your withholdings, you could be under-withholding and hit with a large tax bill come April. In addition, if you exercise ISOs while RSUs are vesting, you could be hit with an even larger AMT tax bill. You will also need to consider a coordination of buying stock (exercising options) and selling stock in order to not violate IRS wash sale rules if the stock has experienced a loss in value.
Generally, when a company IPOs there is a lock-up period in which you cannot sell your stock. This is typically 90-180 days after the IPO. You need to ensure you have sufficient cash flow to get you through this lockup period without tapping into your company stock. When companies IPO toward the end of the year, their lockup period can carry forward past April 15th, so prudent tax planning should be done to understand if there will be a big tax bill due since you will be constrained on your ability to sell stock to raise cash. In some instances, your company may offer an early release in which they allow you to sell a certain percentage of your shares on a very specific date during the lock-up period. This can be a great way for employees to de-risk after an IPO but before the lock-up period ends. For many of our executive level clients, they also have pre-clearance issues as well as open trading windows to navigate through while selling their company stock. For some, a 10b5-1 insider trading plan might be an appropriate way to navigate your company’s insider trading policy while maintaining a stock disposition plan.
As you can see, navigating decisions surrounding your incentive stock options and company stock are complex but the payoffs of having an active plan and expert advice can be tremendous. If you have company equity and would like assistance in navigating these complex decisions, please click here to request a complimentary introductory phone call.
About The Author:
Dave Alison, CFP®, EA, BPC® is an accomplished financial, tax, and investment advisor with a passion to help individuals achieve financial freedom. His professional capabilities to engineer advanced financial, tax, investment, insurance and estate planning needs into one holistic plan led him to found Alison Wealth Management, which serves clients across the United States. Dave is national thought-leader, speaker, and industry trainer on holistic financial planning including specializations in the coordination of taxation and financial planning, equity compensation such as NQSOs, ISOs, RSUs, Founder's Stock, and ESPPs, and retirement income distribution planning.