A series of strategies for tax-wise investors. Table of Contents.
“Incentive Stock Option” is IRS lingo for a particular kind of employee benefit with a potential tax-favored payoff. The deal involves getting long-term capital gain treatment on what is, in effect, compensation for labor.
ISOs have limits. In any calendar year you can get these options on only $100,000 worth of stock. Let’s say you get an option on 20,000 shares, with a strike price of $5, when the shares are worth $5. And let’s say the company goes places. When the stock is worth, say, $20 a share, you exercise the option. You write out a check for $100,000 and acquire shares worth $400,000. You have made an instant paper profit of $300,000.
The goal it to have that $300,000 taxed as a long-term gain, which is a gain on an investment held for longer than a year. This is doable, but the downside is that the $300,000 is potentially subject to “alternative minimum tax.”
The alternative tax regime runs in parallel with the regular tax, and you owe the higher of the two. It’s not common for people to end up owing more under the AMT than under the regular tax, but it does happen. So, while the AMT may or may not turn into an obligation to send an incremental check to the IRS, it’s a hazard that can’t be ignored.
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There’s an out from the AMT. If you sell the shares in the same year as exercising the option, the difference between the sale price and $5 is treated as ordinary income and the AMT problem vanishes. In other words, if you are willing to give up any hope of getting long-term treatment of your gain, you can ignore the AMT threat altogether.
If, on the other hand, you can hold your breath for a whole year after using the option to buy shares, and you also hold the stock until at least two years after the option was handed to you, the difference between the sale price and $5 is a favorably taxed long-term capital gain. That favorable rate on regular tax can make up for the potential liability from the alternative tax.
Maneuvering around these rules is a tricky business, but here’s a solution that works for many employees: Exercise an option in early January after holding that option for at least a year. Then look at the stock in late December. If it’s down from where it was at exercise (say, it drops to $12 in our example), you sell and pay ordinary income tax on whatever profit is left ($7). That protects you from having $15 of phantom AMT income when you’re only $7 ahead.
If the stock is up in late December (let’s say, to $45), you hold on for a little longer. If you sell in mid-January, that will be more than two years after you got the option and more than a year after you turned the option into stock. Then the whole gain ($40) is taxed at a favorable rate. There would still be some AMT income ($15 a share) for the previous year, but this will be tolerable if you’re making a killing on the stock and if that profit is favorably taxed for non-AMT purposes.
This essay won’t delve into all the nuances of the weird AMT, which is likely to affect only investors with very big ISO winnings. The important takeaway is that a January/December timing scheme maximizes your chance of scoring a long-term capital gain while minimizing the risk of owing AMT on a stock that crashes after you exercise. There have been sad stories of people who ran up AMT bills that they couldn’t pay because they held on to their employer stock too long and saw it sink.
There’s more detail in this Turbo Tax discussion.