So, you ended up with a pile of valuable stock options. People keep telling you this is a good thing, and they’re right! But what those same people can easily overlook is the potential financial headache these same options can create. Taxes, diversification, timing, and most importantly long-term financial security, are all significant roadblocks that stand in the way of any potential windfall.
A few weeks back I wrote about the benefits of diversification when faced with concentrated stock positions. What I didn’t cover is how to go about exercising options – the events often leading to concentration. Unfortunately, this area is often overlooked, but it can be a critical one. Having the appropriate strategy in place can generate liquidity while simultaneously minimizing the tax impact. Of course, every situation is unique and there is no one-size-fits-all approach. But there is a common list of items to consider. Much depends on the type of options you hold. Please note, I am not a tax expert, and one should always consult a tax advisor when developing their personal strategy.
Statutory vs. Non-Statutory Options
Non-statutory options (NSOs), also called non-qualified options, are typically used by more mature companies. They represent a form of compensation that can be issued to employees, contractors, consultants, and others. According to the IRS, ordinary income tax is due on the difference between the exercise price and the stock’s fair market value on the grant date. But it is uncommon for a fair market value to be readily attainable on the grant date. As such, the taxable event most often occurs upon exercise – ordinary income tax is due on the difference between the strike price and fair value on the exercise date.
Statutory options differ. The most common form is called an incentive stock option (ISO), and unlike an NSO it can only be issued to employees of the firm. ISOs are more typical of earlier stage startups, and they enjoy favorable tax treatment. There is a $100,000 annual limit on the face value that can be issued to a single employee. According to the IRS, taxation only occurs when the stock is sold. However, this doesn’t mean you’re in the clear when you exercise. The spread on exercise is still counted as a preference item towards Alternative Minimum Tax (AMT). And triggering AMT can create a sizeable tax burden with the top rate currently at 28%. But if you exercise, and you hold the stock for at least two years from the grant date and one year from the exercise date, you qualify for long-term capital gains/loss treatment. Selling early disqualifies the options and essentially turns them into NSOs. You would then owe ordinary income tax on the spread between the strike price and fair value on the exercise date.
Formulating a Strategy
So when is the best time to exercise? This is a very difficult question to answer as it entirely depends on your unique situation. Obviously if the options are out of the money there’s no need for concern. And if they’re only a little in the money, say less than 20%, it almost never makes sense to exercise – you assume all of the downside risk for no more upside than the potential taxes. But if they’re deep in the money you have some things to think about. For one, as soon as you exercise, you put your own capital at risk. In the case of NSOs you would owe ordinary income tax on the spread at exercise. And for ISOs, you could trigger AMT. A nightmare scenario would involve exercising and generating a huge tax bill, only to have the stock price plunge (which you held onto), leaving you unable to pay your tax bill. Many have filed for bankruptcy under such scenarios.
Let’s consider deep in-the-money NSOs and ISOs. The first thing to recognize is even though you haven’t exercised, the options should still be viewed like a regular concentrated stock position. They represent untapped capital, but positive capital nonetheless. And if the stock price drops, that capital is lost. So unless you have a crystal ball and know the stock price will rise, it probably makes sense to exercise some, if not most, of the options. How much and when depends on the type of options and the investor. For NSOs, there is no tax benefit to exercising and holding the position. Remember, these are taxed at your ordinary income rate at the exercise date. It then comes down to your financial situation. If you have a relatively modest net worth with few investment assets, exercising would likely result in a concentrated position – in this scenario you should diversify. Doing so would significantly reduce portfolio risk and allow you to pay the associated tax bill. However, if you have sizeable net worth and significant investments, you are more capable of holding the position since it represents a much smaller portion of your overall portfolio.
ISOs are a little more complicated given the tax benefits of holding the position for a year after exercise (and two years after grant). For the same modest net worth investor described above, it probably makes sense to exercise, sell early, and diversify. In other words, the concentration risk likely outweighs the tax benefit of exercising and holding. But it’s a different story for the individual with sizeable investment assets. Here, developing a longer-term liquidity strategy makes more sense. The key is figuring out what will trigger AMT and staying under this amount. A tax professional or TurboTax can be helpful in determining this.
If you expect a relatively stable stock price, exercise the vested ISOs on the 366th day (one year after grant) and hold the stock for a year to take advantage of the tax benefits. It is important to note you have until 12/31 in the year of exercise to sell the stock and disqualify the ISO. This can be very beneficial. Let’s say you exercise when the stock price is sky high relative to the strike, and later find out it will trigger AMT – then the stock price plummets. You could sell before 12/31 in the year of exercise and pay ordinary income tax, of which you could also apply the capital loss from the stock’s decline. In other words, disqualifying the ISO may result in a lower tax bill relative to holding the stock and paying AMT. If you expect the stock price to fall, exercising, selling, and paying ordinary income tax might be the best course of action, depending on the extent of the fall. If you expect the price to increase, exercising and holding (at least two years from grant and one year from exercise) should maximize your gain (assuming you don’t pay AMT).
The Most Important Consideration
I’ve gone over some potential strategies, but the primary focus for everyone should be liquidity and financial security. Taxes are very important, but are not necessarily the number one priority. It’s about your own financial security, and sometimes that means you have to pay a lot in taxes. You may have a lot of risk, so it makes sense to consult a tax advisor and investment professional before generating your own liquidity strategy.
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.
Any reference to the advisory services refers to Personal Capital Advisors Corporation, a subsidiary of Personal Capital. Personal Capital Advisors Corporation is an investment adviser registered with the Securities and Exchange Commission (SEC). Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC.