Why You Might Want to Exercise Your Incentive Stock Options Early in the Year

Overview

The strategies outlined in this post will allow you to potentially benefit from the special tax treatment of Incentive Stock Options (ISOs) while reducing your downside risks. If your company has recently gone public or is expected to this year, you should definitely be aware of these potential strategies!

ISOs and Taxes

Exercising and holding ISOs does not create ordinary tax liability but the spread between the exercise price and the fair market value (FMV)–as determined by the 409A valuation if the stock is not yet public–can create Alternative Minimum Tax (AMT) liability.

If you exercise your ISOs and hold them for at least one year (and two years from grant date, which is normally built into the vesting schedule if you don’t early exercise) before selling this is a qualified disposition, which means that the gains over the exercise price will be taxed at more favorable long-term capital gains rates instead of ordinary income tax rates, resulting in a larger after-tax payday.

But if you are relying on the eventual sale of the stock to cover the tax bill in the interim, this can lead to a lot of pain if the stock declines massively in value. During the dot-com boom, there were countless tales of those who exercised ISOs at high valuations which then crashed back down to earth, leaving them with no equity to pay the AMT bill from exercising their ISOs. Some of those on the hook got bailed out in 2008, but we’d rather help you avoid this scenario to begin with!

For informational purposes I’ve created an estimated AMT calculator HERE.

Reasons to Exercise ISOs at the Beginning of the Year

Flexibility to Avoid an AMT Bill You Can’t Pay Back

Exercising ISOs early in the year gives you the flexibility to monitor the stock’s performance throughout the year. If the value of the stock plummets to where you wouldn’t be able to afford the AMT bill even if you sold all your shares, you now have the flexibility to intentionally disqualify your ISOs before the end of the year by selling them to avoid being stuck with an AMT bill.

Flexibility to Reduce Your Tax Bill

Disqualifying your ISOs with a sale before the end of the year will alter their tax treatment. Depending your situation (see “When Should You Consider Selling/Disqualifying Your ISOs Before the End of the Year” below) this may result in a more favorable tax situation.

Flexibility to Pay the AMT Bill with Tax-Optimized Proceeds

By exercising ISOs early in the year, you’ll have time to sell some/all of your shares at the more favorable long-term capital gains rates next year to raise the cash needed to pay your AMT bill before the tax deadline in April.

Reasons NOT to Exercise ISOs at the Beginning of the Year

You can’t afford the exercise cost

Exercising ISOs requires you to pay the exercise cost up front. If you can’t afford this cost, or would seriously extend yourself in doing so, this may not be the right strategy for you.

You might be subject to an IPO lockup and/or blackout periods

If your company is expected to go public this year, you still may not be able to sell before the end of the year due to an IPO lockup period. Six months is a common time period for this, but terms can vary, both for the lockup period and for the timelines of the IPO process.

Further, even if your IPO lockup is lifted, you may additionally be subject to blackout periods during which you cannot sell your shares, in which case you’ll have specific open trading windows. Check with your company to understand their policies and open trading windows. If you are a director, you are subject to additional restriction and may have to create a 10b5-1 trading plan to sell your shares.

You’d rather not risk the chance to miss out on the sure gain you already have

If you are worried about the potential for your paper gains to disappear, it may be worth considering taking some of your chips off the table while you can. For a more comprehensive post on this decision process, check out my IPO Guide.

Depending on your company’s  policies, you may be able to cashless exercise with sell-all or sell-to-cover-taxes options or simply exercise your options and immediately sell them.

A common strategy is to take a hybrid approach by realizing some immediate gain, perhaps for some specific goal(s), while holding onto some shares for the potential of more favorable tax treatment (and potentially gain if the stock appreciates).

When Should You Consider Selling/Disqualifying Your ISOs Before the End of the Year?

Disqualifying your ISOs with a sale before the end of the year will cause the spread between FMV and strike price to be treated as ordinary income instead of income only for purposes of AMT. This ordinary income, however, will be offset by capital losses if the stock has plunged below your exercise price.

This is a great strategy when the price of the stock has fallen below your exercise price.

When the price of the stock has fallen substantially since you exercised but is still much higher than your exercise price, you’ll need to run the numbers to compare which tax situation is more favorable.

Conclusion

Exercising your ISOs early in the year can be a strategic way to set yourself up to benefit from long-term capital gains treatment, while also giving you more flexibility to pay for your AMT bill or avoid it entirely. By exercising early in the tax year, you may be able to avoid paying an AMT bill you can’t cover if you decide later to “disqualify” your ISOs (i.e., sell before meeting the favorable holding-period requirements) due to a substantial drop in value. This timing can also give you the opportunity to strategically generate cash from a sale early next year and use it to pay AMT in a more tax-efficient manner.