ISOs and Year-End Planning

Posted on Mon, Dec 21, 2020 ©2020 Drucker & Scaccetti

Personal-Financial-PlanningBy: Beth Gaasbeck, CPA, MBA

 

Incentive stock options (ISOs) are granted each year as part of compensation packages for many executives and key employees. Once stock options are granted, though, executives are left with a decision that requires careful consideration: When is the right time to exercise my options? And, with possible tax rate changes on the horizon, that question has become more difficult than ever.

 

But before we can get there, it is important to review the requirements for options to qualify as ISOs, the tax differences between ISOs and nonqualifying stock options (NQSOs), and the impact exercising options will have on your cash flow.

 

What is an ISO?

Stock options that meet certain IRS requirements are classified as "qualified" options, which are more commonly referred to as ISOs or "statutory" options. Stock options that don't meet those requirements are referred to as "nonqualified" options (NQSOs). The distinction is critical as the taxation of ISOs and nonqualified options is different. Since the requirements for ISO qualification are extensive, we'll forgo that discussion here, but you can refer to our previous blog for more detail.

 

Tax Differences Between ISOs and NQSOs

Generally, the taxation of ISOs is more advantageous than NQSOs, since (1) the taxation of ISOs can generally be deferred longer than NQSOs, and (2) a greater portion of taxable income from ISOs can qualify for lower capital gain tax rates than NQSOs.

 

Below is a quick summary of the key differences:

When Granted: Stock options, whether qualified or nonqualified, are generally not taxed when they are granted, as the employee may not end up exercising the options.

 

When Exercised: Employees with NQSOs will recognize ordinary income upon exercise, generally reported as wages on their W-2, for the difference between the fair market value (FMV) of the shares on the exercise date and the option exercise price (the bargain element). The wage income will be subject to federal and state income taxes and employment taxes.

 

In contrast, options that meet all the ISO requirements are not subject to regular income tax or employment tax upon exercise. They are, however, subject to an alternative minimum tax (AMT) adjustment for the bargain element. In 2020, taxpayers are eligible for an AMT exemption ($72,900 for single filers, $113,400 for joint filers) if their taxable income (for AMT purposes) is under the phase out threshold ($518,400 for single filers, $1,036,800 for joint filers). When considering when to exercise ISOs, it may be advisable to wait until a year when you expect your income to be below the AMT exemption phase out thresholds to avoid the AMT hit.

 

When Selling: Employees who sell shares received from ISO exercises will recognize capital gain on the difference between the FMV of those shares on the date the shares are sold and the option exercise price previously paid, provided they meet the following employment and holding period criteria:

  • The option holder is an employee at all times from the date the option was granted until 3 months before the option was exercised; and
  • The employee does not dispose of the stock acquired by exercise for at least 2 years from the day the ISO was granted and at least 1 year from the day the exercised shares were transferred.

If the above criteria are met, the bargain element, which is taxable as ordinary income upon exercise for NQSOs, is essentially converted to long-term capital gain when shares received from an ISO exercise are sold. This is where the deferral and capital gain differences comes in.

 

The 1-year holding period requirement for shares received upon an ISO exercise is important to note, as selling the shares prior to achieving this 1-year hold results in a “disqualifying disposition,” which essentially nullifies the ISO tax benefits and causes them to be taxed similar to NQSOs.

 

How much cash do I need?

Evaluating your cash flow is critical when planning to exercise ISOs. If you want to hold the shares after exercise to ensure the favorable ISO tax treatment, you will need cash to pay the exercise price. If you exercise your ISOs in a year you will be subject to the AMT tax, you will also need cash to pay the AMT taxes on the bargain element when filing your return for the exercise year (at roughly 28%).

 

A strategy normally used to decrease your cash outlay upon exercise entails immediately selling a portion of the shares received upon exercise to generate cash to cover the exercise price of all the options. While this strategy can generate cash to pay the exercise price and associated AMT, eliminating an out-of-pocket cost, the shares sold will be disqualified from ISO treatment since they will not hit the 1-year holding period. Accordingly, executives with both ISOs and NQSOs will often exercise and sell their NQSOs to cover the exercise price of their ISO's and any AMT tax hit.

 

When is the “right time” for ME to exercise my options?

There is no universal answer for when someone should exercise their stock options. The decision will differ depending on your current financial position, investment goals, tax attributes, and market conditions. Holding options generally reduces your risk--if the stock price declines below the exercise price, you simply don't exercise the options (no loss). But if you exercise and hold the shares while the stock price declines below the exercise price, you could end up selling the shares for less than it cost you to buy them on exercise.

 

From a tax perspective, those concerned long-term capital gain rates may increase in the future should consider exercising ISOs before the end of 2020 to start the 1-year holding period clock. If legislation is passed that increases long-term capital gain rates effective 1/1/2022, ISO's exercised this December (2020) could be sold next December (2021) at long term capital gains rates before new higher rates take effect in 2022. But of course, this is a bit speculative as there's currently no clear timetable if and when capital gains rates could increase.

 

ISOs can be valuable tools in financial and tax planning, so it is important to consult with both your investment advisors and tax professionals on how they can be used to achieve your individual goals. Drucker & Scaccetti is available for consultations and is experienced in planning for stock options. Call on us to help you strategize and decide when your “right time” should be.

Topics: ISOs, executive compensation, NQSO

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