Note: You may find it useful to review this introduction to stock options before reading this post.
Incentive stock options (ISOs) have significant tax advantages over their sibling (non-qualified stock options). For regular tax purposes, the bargain element of ISOs is not taxable upon exercise and no tax is due until the shares are sold. If you satisfy the special holding period before selling (i.e. two years from date of grant and one year from date of exercise) the bargain element will be converted to a long-term capital gain, which means it is taxed at lower rates. Although holding exercised shares still exposes you to investment and concentration risk, the tax benefits make holding ISO shares very compelling. As a result, many employees will exercise and hold all of their ISOs thinking they are saving a significant amount of taxes and that whatever taxes are paid won’t be due until the shares are sold.
While this can be true, it often is not the case. ISOs would be beautiful if it were not for the dreaded Alternative Minimum Tax (AMT) which significantly complicates your tax situation and can diminish much of the tax savings you thought ISOs had. AMT is a separate and parallel tax system. Every year you calculate your tax liability under the regular system and the AMT system. You then pay whichever tax liability is higher. Many taxpayers never have to contemplate AMT, but if you have ISOs it becomes critical as there is a good chance you will owe AMT in the year of exercise.
Under AMT, incentive stock options don’t receive special treatment, which means the bargain element is considered taxable income upon exercise. If this is a significant amount or there are other impacting factors in your tax return (e.g. if you have high itemized deductions from owning a home) then you could owe AMT. Since it’s not considered compensation income, your employer will not put it on your W2 and it’s up to you to remember to report it. Further, if you use tax software to self-prepare your returns there is a good chance you will miss this as it’s often not part of the normal prompts.
As a result of the complexity, many financial advisors will recommend selling ISO shares immediately after exercise if the company is already public—which essentially converts them to non-qualified stock options and greatly simplifies your tax situation while minimizing risk. However, this is often bad advice and is a classic example of throwing the baby out with the bathwater. If you have ISOs it’s a good idea to speak with a CPA or better yet a CPA/PFS who has experience with stock option planning. A PFS is a designation awarded only to CPAs who have additional education and experience in financial planning. Based on your unique tax situation and risk tolerance a sensible exercise and sell strategy can be developed that will likely result in you paying lower taxes than if you otherwise chose between a blanket hold or sell policy.