Three Strategies for Selling Tax-Friendly Incentive Stock Options

Incentive stock options provide executives with various tax benefits. But when do you exercise and sell the underlying ISO stock? Below is a summary of the basic tax rules and common tax strategies.

Tax Rules for Qualifying Dispositions of ISOs

In a qualifying ISO disposition, the taxpayer benefits from long-term capital gain treatment if the taxpayer meets certain holding period requirements. Specifically, the taxpayer must sell the underlying stock the later of the expiration of two years from the grant date or one year from the exercise date of the stock option.

If the holding period requirements are met, then the tax effects are as follows:

Grant date: There are no tax consequences on the grant date.
Exercise date: The taxpayer recognizes no income for regular tax purposes but does so for alternative minimum tax purposes. The AMT income is equal to the number of shares exercised multiplied by the difference between the fair-market value at exercise less the exercise price. The taxpayer carries forward a minimum tax credit, or AMT credit equal to the excess of the AMT over the regular tax.
Sale date: The gain is capital subject to a 23.8% tax rate for both regular and AMT purposes. The AMT gain is less than the regular tax gain by the amount of AMT income recognized in the exercise year. The AMT credit reduces the regular tax to effectively equal the AMT. The average tax rate on the exercise and disposal of the stock is 23% to 27%, versus the highest tax rate of 37%. The range is due to the AMT credit limitation.

Strategy No. 1: Hold the ISO Stock Long Term

Disposing of ISO shares in a qualifying disposition is the best choice if the stock is expected to appreciate in the year of sale as the average tax rate applied to the gain is between 23% and 27%.

This is the ideal strategy if the stock appreciates. The risk, though, is if the stock price declines. If so, the cash proceeds received in the year of sale could be less than the AMT paid in the exercise year. In this case, the taxpayer is left with no way to recuperate the AMT paid.

If the stock price falls and the sale occurs in a year other than the year of exercise, the tax year closes with respect to the exercise, and the taxpayer is burdened with the AMT. What’s worse is the taxpayer recognizes an AMT capital loss, which is limited to $3,000 per year to offset ordinary income. Due to the AMT capital loss limitation, the taxpayer may never fully utilize the AMT credit.

Strategy No. 2: Dispose of Shares in Exercise Year

If the taxpayer sells the stock in the same year of exercise, it is a disqualifying disposition. This may be the best move if the stock price goes down to limit the AMT exposure. If that is the case, no AMT adjustment occurs. Instead, for both regular tax and AMT purposes, the taxpayer must include compensation income equal to the lesser of the fair-market value at exercise less exercise price; or fair-market value at sale less exercise price. The excess (if any) is treated as short-term capital gain.

The taxpayer will have sufficient cash to cover taxes owed with Strategy No. 2 as compared to Strategy No. 1. The tradeoff with selling shares before the one-year holding period is that the taxpayer pays a higher tax rate but on less income. Income generated from disposing ISO shares in the year of exercise is reported in box 1 of the employee’s W-2 but is not subject to payroll tax withholding. To cover any income taxes owed, the taxpayer should consider either making quarterly estimates or adjusting withholding.

A good strategy would be for taxpayers to exercise ISOs early in the year (January 1 to April 14) and monitor the stock price during the year. If the price goes up, wait until the one-year holding period is met, and sell in the subsequent year in time to pay any tax that may be due on April 15. If the price goes down, taxpayers can sell in the current year to limit the AMT exposure.

Taxpayers who want to sell ISO shares in the same year of exercise to limit the AMT tax should beware the wash sale rules. If the taxpayer reacquires shares within 30 days before or after the sale date (either by purchase, exercise, or vesting), the income limitation does not apply, and the taxpayer must still report the fair-market value at exercise price less exercise price with respect to the number of shares reacquired.

Strategy No. 3: Sell in Exercise Year and Year After

An alternative is to implement a blended strategy, in which the taxpayer sells a portion of the shares in the exercise year to break even for AMT. Next, they can sell the remaining shares in a following year. When a taxpayer is in AMT, the top rate is 28%. Therefore, if a taxpayer recognizes ordinary income by exercising options and/or selling ISO shares, then the income will be taxed at 28% if the taxpayer is still in AMT. The strategy is to get to the break-even point, in which the regular tax is close to or equal to the AMT.

At the break-even point, taxpayers are subject to an average tax rate hovering around 30%, as opposed to the highest tax rate of 37% on ordinary income. Taxpayers receive cash on the shares sold to pay the tax. The blended strategy results in less risk exposure to stock price volatility as in Strategy No. 2. Simultaneously, the taxpayer may benefit from the potential upside for those shares sold as in Strategy No. 1.

Key Takeaways

Stock prices, tax rates, and cash flow are critical factors to determine the best strategy for disposing of incentive stock options. Strategies No. 1 and No. 2 are most effective when the stock price is expected to increase or decrease, respectively. Strategy No. 3 works well when the stock price is volatile.

The above discussion focuses on federal tax rules. One should check state tax rules, especially for states that impose the AMT (such as California). Special rules may apply for taxpayers who move to another state. Because of the many complexities involved, it is important to evaluate each strategy with both your tax and investment advisers.

—Scott Testa contributed valuable research to this article.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Alyssa Rausch is a senior tax manager in EisnerAmper’s private client services group. She has more than 15 years of experience in providing comprehensive tax compliance and advisory services to high net worth individuals, closely held businesses and their owners, S corporations and partnerships.