Avoid These 4 Costly Mistakes with your ISOs
The tremendous upside potential and unique tax benefits of Incentive Stock Options (ISOs) make them particularly attractive for executives. ISOs are complex, however, and mistakes are easy to make, which can be very costly.
Knowing a few key aspects can help you make smarter decisions, avoid missed opportunities, and, most importantly, avert disaster.
A quick refresher on options:
Stock options give key employees the option to buy company stock at a set price over a stated period. Two things must happen for options to have value:
1) the price of the stock must increase after it’s granted and,
2) the employee must take action by exercising the option before it expires.
The two major types are ISOs and non-qualified or non-statutory options (NQs/NSOs). The main difference between the two is the tax treatment.
- With NQs , you pay ordinary tax at exercise. If you hold the stock, it’s capital gains from that point forward.
- With ISOs, you pay no tax at exercise and capital gains on the spread when you sell the stock. There is one catch, however. The spread can trigger alternative minimum tax (AMT) if the stock is held.
Here are four common mistakes to avoid when it comes to ISOs:
1. Thinking “AMT won’t happen to me” – Even though the rules changed favorably a few years ago and the risk of AMT is lower, it’s still possible. Always have your CPA prepare a projection before you exercise ISOs to determine if it will generate AMT. AMT is not always bad, but it’s best to avoid surprises and not be reactive. You also want to be sure you have funds to cover it and not be forced to sell investments at a bad time.
2. Prioritizing tax savings over investment risk – options are inherently riskier than owning stock outright. While they have tremendous upside potential, they can also expire worthless during a market downturn. With ISOs, too much focus is often placed on meeting the holding period requirements to get the preferred tax treatment. This can be disastrous if you are overexposed to company stock and emphasizes the need for sound financial planning to see how much you can afford to risk.
3. Exercising ISOs too late in the year– if held ISO shares trigger AMT and subsequently drop in value, you can eliminate AMT by selling the stock. However, you must do this during the same calendar year you exercise. Exercising ISOs early in the year provides more of a runway to see how the stock performs and more time to undo it. It also simultaneously starts the clock sooner for meeting the holding period requirement in addition to that “free-look” period. Wait too long, and you may end up owing more tax than necessary or worse, owing more in AMT than the stock is worth.
4. Losing track of expiration dates. This is incredibly simple and likely to generate an eye roll from all those reading this. But according to a recent PIMCO webinar on this topic, approximately 11% of all company options expire worthless. This is a huge amount of missed wealth opportunity. In addition, ISOs must be exercised within 90 days if you terminate employment. If you decide to leave and exercise too late (per point 3 above) and/or don’t meet the holding period requirements, you can disqualify the tax treatment on the ISOs.
The world of ISOs is always evolving. Please don’t hesitate to reach out to us if we can be a resource.
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No representation is being made that any strategy shown will or is likely to achieve results similar to those shown in this presentation. BDF does not provide legal, tax, insurance, social security, or accounting advice. Clients of BDF should obtain their own independent tax, insurance, and legal advice based on their particular circumstances. The information herein is provided solely to educate on a variety of topics, including wealth planning, tax considerations, insurance, estate, gift, and philanthropic planning.
Gary is a Wealth Manager at BDF and member of the Firm’s Investment Committee. He specializes in executive and stock-based compensation plans, including stock options, restricted stock and deferred compensation. He combines his tax knowledge, executive compensation experience and capital markets expertise to help clients reduce their tax burdens and achieve each of their unique goals.