Incentive Stock Options (ISOs) have long been popular tools for corporations looking to tax-efficiently retain and reward key executives and other employees. Yet they can pose unique challenges and require focused planning and expertise to fully optimize, given their complexities. We will discuss tax planning opportunities that can greatly impact executives with ISO awards.
General Tax Treatment of Incentive Stock Options (ISOs)
Internal Revenue Code Sections 421-424 govern the tax treatment of ISOs, providing them with potentially lucrative benefits. The grant of ISOs is not considered a taxable event for regular tax purposes; only when exercised do ISOs trigger potential tax exposure.
Alternative Minimum Tax (AMT) Adjustment
While no regular taxable income occurs with an ISO exercise, a federal Alternative Minimum Tax (AMT) positive income adjustment on the Internal Revenue Service (IRS) Form 6251 for the option spread amount occurs for that tax year. The spread amount is the difference between option “exercise” or “strike” price, and the market value of shares received at the exercise of the option and is often referred to as the “bargain element.” For many taxpayers, a large AMT adjustment from ISO exercise can result in substantial federal tax in the exercise year. No adjustment occurs if ISO stock is sold in the same year as the exercise, due to the spread amount included in regular taxable income and thus, not a preference item for AMT. However, the AMT adjustment from ISO exercise also results in higher tax basis in the stock shares received from that exercise for AMT purposes than for regular tax purposes by the bargain element amount. Generally, this causes AMT income to be lower than regular taxable income, with respect to the related stock in the year when it is sold, since AMT gain should be lower than regular tax gain on those shares.
Additionally, the AMT triggered in the exercise year will usually result in some AMT tax credit on Form 8801. This credit often provides some benefit in future years from carryforward when regular tax exceeds the AMT. The AMT effect from ISO exercises mainly consist of timing issues, that are potentially alleviated by the AMT credit carryforward and lowered by the AMT gain in the sale year.
Qualifying Disposition of Incentive Stock Options (ISOs)
One of the most attractive features of ISOs is the ability to qualify for long-term capital gain treatment on stock shares acquired from an ISO exercise. For such qualifying disposition, the shares must be held for more than one year from the exercise date and two years from the option grant date, meaning the employee-shareholder must cover the option price on the exercise to buy-and-hold those shares.
Timing ISO Strategies
Reducing AMT Exposure on ISO Exercise:
- Spread ISO exercises out over time to avoid large spikes in the AMT income in a single year. There may be limitations for various reasons, including vesting schedules imposed by the corporation, cash constraints, concentration risk concerns and other factors. Additionally, the general requirement is that ISOs must be exercised within 90 days of employment separation to retain ISO treatment.
- Implement ISO exercises during years when sales of other stock shares are acquired from earlier ISO exercises with AMT bases higher than regular tax bases. This should at least partially offset the positive and negative adjustments.
- Time ISO exercises to occur in years when large ordinary income events occur, such as bonus income, Restricted Stock Unit (RSU) vesting and payout, or gain from Non-Qualified Stock Option (NSO) exercises. While the AMT adjustment from ISO exercise may be substantial, it might not be enough for the AMT to exceed regular tax that year.
- Avoid ISO exercises in years when large capital gains are triggered, as this can indirectly result in more AMT exposure in those years.
- Exercise ISOs when the stock price dips but is expected to recover. Such timing involves guesswork and can be very tricky.
- Consider exercising ISOs early in the tax year, when possible, in case the stock price declines or other factors dictate a stock sale earlier than expected. If the shares are sold within the same tax year as exercise, the sale should be a disqualifying disposition, meaning the bargain element is reported on the employee’s W-2 for that year as it would with an NSO and no AMT adjustment occurs.
Financing ISO Strategies
Cash requirements for ISO exercises can pose challenges when the strike price or number of options is substantial, and the employee wants to buy-and-hold the shares to obtain long-term capital gain treatment. Several potential financing solutions exist, including:
- Loans, which are often secured by the stock shares and available from third-party lenders. These may often come at high interest rates, fees or other offsets.
- Partial cashless exercise, where enough shares are immediately sold to cover the strike price of the ISOs. This results in a disqualifying disposition for those shares and ordinary income is immediately triggered for the bargain element amount on that sale.
- Stock swap (plan-permitting), in which the employee-shareholder can swap existing shares in a tax-free exchange with the corporation for newly issued shares in the ISO exercise transaction, defraying some or all of the strike price amount. This can also tax-efficiently reduce concentration risk in that stock, when an employee-shareholder has accumulated a large position but still wants to utilize existing ISOs. This strategy results in zero basis on the additional shares issued from the ISO exercise, which are always deemed to be sold first in a disqualifying disposition. The shares received from the swap portion of the exercise transaction will have carryover basis from the old shares relinquished.
While these tax planning strategies can offer tremendous savings, other financial considerations usually weigh heavily into ISO related decisions, including stock concentration risk, market factors and liquidity management. ISO planning should generally involve seasoned tax and investment advisors to help achieve optimal overall results.
How Can Cherry Bekaert Help Implement Incentive Stock Options Strategies
Our dedicated team can help find solutions for your specific situation, address important tax matters and assist with financial planning. If you have questions, concerns or want assistance implementing Incentive Stock Options strategies, please contact our Private Client Services practice or your Cherry Bekaert advisor.
