Fortune favored Jack, or so he thought. Three years ago he landed his dream job, with a nice salary plus incentive stock options (ISOs).
Jack — and pretty much everyone else — saw an IPO in the company’s future. When the company did go public and he exercised his options, Jack was a wealthy man.
Then came the volatility. As with Facebook, and more recently Twitter and Zulily, post-IPO stock prices don’t always head up and stay there. They can and often do fall below the issuance price, at least for a time.
So how do you decide if or when to exercise your options or sell your stock? Ultimately, it’s an investment decision — one with significant financial and tax consequences based on the timing.
To understand the risks, let’s start with a little basic background.
Introduction to ISOs
An ISO is a type of stock option granted to a company’s employees as a form of compensation. It can provide significant advantages over other types of options, including nonqualified stock options.
For example, ISOs do not generate taxable income to you when you exercise the options.
Tax and Cash Flow Considerations at Exercise
Although you don’t have ordinary taxable income when you exercise your options, there’s a different potential downside to consider. You may find yourself subject to the alternative minimum tax (AMT).
For federal tax purposes, the difference between the price you pay for your shares and their fair market value at exercise becomes part of the AMT calculation for the year they’re exercised. The only exception is if you sell your stock in the same year the underlying options were exercised. In this case, there are no AMT consequences from exercising the options.
If you do owe AMT, it’s due for the tax year that you exercise the options. For example, assume you exercise options in 2014 and still hold stock at year-end. The AMT calculation is performed for your 2014 tax return, filed in 2015. Ignoring any estimated tax considerations, the AMT must be paid with the return or extension request. If you haven’t sold stock to generate cash, you could find yourself with a hefty tax bill and no money to pay for it.
On the plus side, some or all of your AMT liability may generate an AMT credit that reduces your regular tax liability in future tax years when you are not subject to AMT. Also, the amount of the AMT adjustment increases your basis in the stock for future AMT calculations.
Tax and Investment Considerations When Selling the Stock
Selling your stock is first and foremost an investment decision, but one with potentially significant financial and tax consequences.
Those consequences depend on whether you’ve met the IRS requirements for favorable ISO tax treatment, referred to as a qualifying disposition. To do so, you must hold the stock more than two years from the date the options were granted and more than a year after the options were actually exercised. There’s an additional requirement that you were employed by the employer granting you the ISOs from the grant date to at least three months before exercising them.
The tax treatment also depends on whether the stock price is higher or lower than your exercise price.
Selling When the Stock Price is Up
When you sell your stock, you have federal taxable income equal to your gain on the sale. This gain is the difference between the amount you paid for the shares (your basis) and their fair market value at the time of the sale.
So why does the timing of the exercise matter when it comes to the stock sale?
The federal taxable income from your stock sale may qualify as long-term capital gain rather than ordinary income if you held it long enough to meet the tax requirements for a qualifying disposition. Further, and just for ISOs, if you’ve satisfied the holding period requirements the resulting income is not considered compensation for tax purposes, including for Social Security and Medicare tax purposes.
Alternatively, if you sell before the end of the holding period, it’s a disqualifying disposition and you don’t receive the favorable ISO treatment. You’ll pay income taxes at the higher ordinary income rates and be subject to Social Security and Medicare taxes on the difference between the exercise price and the fair market value at exercise. It’s considered compensation. Any remaining gain is considered to be a capital gain.
The implications for AMT? Let’s assume you exercised your options this year and you choose to sell a portion of the resulting shares to pay the AMT due next year. If you exercised your options on or after April 15 and you want to qualify for the preferential ISO tax treatment, you can’t sell the stock in time to provide cash for your AMT liability. Remember, you must hold the stock at least a year and a day before selling. If you exercised the shares on May 20, the taxes are due by April 15 of the following year even if you extend your return, but the holding period isn’t up until May 21 of that year.
Exercise your options before April 15 if you want to provide cash for next year’s AMT liability without sacrificing the beneficial ISO tax treatment. The impact on your cash flow and tax bill can be quite significant.
Selling When the Stock Price is Down
When you sell your stock and the selling price is less than your basis, you have a loss for federal tax purposes. The general rule here is that the entire amount is a capital loss and there is no compensation to report.
However, you may still have a sizeable AMT liability resulting from the exercise of the options. In other words, you may be required to pay taxes on an investment that actually lost value.
Interestingly, this is one time when a disqualifying disposition may actually be beneficial. If the share price falls below the fair market value at exercise — or you believe it will do so by year-end — it’s time to at least consider selling. With a disqualifying disposition, if you sell the stock by the end of the calendar year in which the options were exercised you avoid AMT. But you still recognize compensation for the difference between the exercise price and the fair market value at time of sale.
Of course, you may decide that none of this matters if you believe the share price will recover and your investment will be a valuable one over the long term.
The tax rules regarding stock options and the resulting shares are exceedingly detailed and complex, and each situation is different. Get great advice to help you understand the financial and tax impacts, as well as any restrictions that govern the exercise of ISO options.
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