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Updated March 17, 2016

Timing is everything — especially when it comes to your investment portfolio. Sell or buy at the wrong time and you can lose a bundle.

In the case of incentive stock options (ISOs), timing can be even more critical. In fact, if you don’t plan carefully, you could easily increase the taxes you owe or find yourself with a hefty tax bill and no cash from the ISO shares to fund it.

But if you exercise your ISOs before the due date of your federal income tax return, you could significantly enhance your cash flow and possibly even reduce your federal tax bill.

To understand why, let’s start with a little background on ISOs. An ISO is a type of stock option that can be granted to a company’s employees. This type of stock option can provide significant advantages over others, including nonqualified options.

Tax Advantages of ISOs

ISOs do not generate taxable income to you when you exercise the options, only when you sell the stock. The taxable income at sale is equal to your gain — in other words, the difference between the amount you had to pay for the shares (your basis) and their fair market value.

The resulting taxable income can qualify for treatment as long-term capital gain rather than ordinary income, as long as you hold the stock long enough. In this case, the holding period is a two-part test. You must hold the ISO shares for more than two years from the date of the option grant and more than one year from the date of the option exercise.

Unlike nonqualified options, if you’ve satisfied the requisite holding period, the income is not considered compensation and therefore is not subject to Social Security taxes.

AMT Implications

Now for the downside: you may find yourself subject to alternative minimum tax (AMT). When you exercise your options, the difference between the price you pay for the shares and their fair market value becomes one part of the alternative minimum tax AMT calculation and may be enough to subject you to this additional tax.

The AMT you owe, if any, is due for the tax year that you exercise the option, whether or not you’ve sold any of the shares. So you could find yourself with a hefty tax bill and no cash to pay it — unless you borrow.

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.

Importance of Timing

So, why does the timing of your exercise matter? Let’s assume you intend to exercise options in 2016 and you’ll need to sell a portion of the resulting shares to pay any resulting tax liability.

While there is no taxable income stemming from the ISO exercise, you may be subject to AMT. The AMT calculation is performed with regard to your 2016 tax return, since you’re exercising the options in 2016. Ignoring any estimated tax considerations, that means the AMT won’t be due until April 2017, the due date of your 2016 tax return.

  If you exercise the options before the April 18 due date this year, the shares you receive upon exercise will qualify for capital gain treatment by the time your 2016 tax return is due April 18, 2017. You can sell the ISO shares in time to fund your AMT liability. (Note that, when planning the sale of your shares, you should factor in the time it takes to actually receive the money from selling the shares.)

  If you exercise the options on or after April 18, you’ll have to hold the shares until at least April 19, 2017 (i.e., more than one year) to meet the special holding period requirement for ISOs. That means you can’t sell the shares to provide cash for your AMT liability without sacrificing the beneficial ISO tax treatment. In other words, if you don’t own them long enough to satisfy the special two-part holding period, you’ve made what is known a disqualifying disposition and your gain will be taxed as compensation at the higher ordinary income tax rates.

Interestingly, there is one time when a disqualifying disposition is actually beneficial: when the stock price has decreased dramatically and you don’t anticipate it will recover. In this case, you should sell the ISO shares in the same year that you exercise them to offset any AMT.

Example

The cash-flow impact of exercising before, rather than after, the federal tax due date in any tax year can be significant — as illustrated in the simple example below. Both scenarios assume you hold the stock long enough to qualify for ISO and long-term capital gain treatment.

Under the first scenario, where you exercise before April 18, you can sell your ISO shares in time to pay the AMT due with your tax return and the sale of the stock is sheltered by the AMT credit.

Under the second scenario, you have to fund the tax liability without selling the new shares.

 

  Exercise before April 18, 2016 Exercise after April 18, 2016
Number of Shares 10,000 10,000
Exercise price per unit $1.00 $1.00
Fair market value per unit $10.00 $10.00
Gain per unit $9.00 $9.00
Taxable gain $90,000 $90,000
2016 AMT $25,200 (at 28% rate) $25,200 (at 28% rate)

You won’t be able to sell the new shares to fund this tax payment without losing the ISO tax benefit

2017 federal income tax on the gain from sale of 1,000 shares of stock $13,500 (at 15% long-term capital gains rate), less AMT credit $31,500 (at 35% marginal income tax rate), less AMT credit
AMT credit Approximately $13,500 Approximately $13,500
AMT carryforward Approximately $11,700 Approximately $11,700
2017 tax benefit of carryforward, assuming no AMT in that year Generally between $2,000 and $4,000 Generally between $2,000 and $4,000
Total 2016 tax related to options exercise $25,200 $25,200
 Tax benefit for future years
$11,700 $11,700

The tax rules regarding stock options are exceedingly detailed and complex, and each person’s tax situation is unique — for example, you might have a cashless exercise option in your plan or already own stock you have held for more than one year.

As a result, you’ll want a more detailed analysis and expert advice to understand the financial and tax impacts, as well as any windows or other restrictions that govern when you can exercise your options.

 

SEE ALSO Been Granted Stock Options? Maximize the Benefit

SEE ALSO Exercising ISOs? How to Minimize the Investment and Tax Risks in Selling the Stock

SEE ALSO Receive Stock Options or RSUs from an Employer? You May be Able to Defer Taxable Income With an 83(i) Election

 

 

 

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SCOTT USHER
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KELLY NELSON
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