Tax planning when exercising your stock options and selling your company stock

Tax planning when exercising your stock options is essential to manage your tax risk, maximize your gains and avoid any unpleasant surprises with the IRS. If you are sitting on a pile of ISOs and NSOs, now is the time to consider exercising some of these grants.

The tax impact of exercising your stock options can be complex. There are many moving parts, and everyone’s circumstances are different. I am sharing some ideas with you on how to plan for exercising your stock options. Whether you aim to exercise at year-end or throughout the year, there is no one-size-fits-all strategy.

Feel free to make an appointment if you have any questions.

Exercise your ISOs up to the AMT breakeven limit.

Exercising ISOs are not subject to Federal and state income taxes, but you may pay Alternative Minimum Tax. The AMT is a parallel tax system that adds certain income, such as the ISO bargain element and the interest from certain types of Municipal bonds, to your regular income. Furthermore, the AMT system uses two tax brackets – 26% and 28%, respectively- with its own standard deductions. The AMT typically impacts just 0.1 percent of US households overall.

Most people receive an AMT exemption every year. The annual exemption is the difference between what you owe on your regular tax income and the AMT calculation. You may know it as AMT breakeven.

You can exercise enough ISOs annually to keep you under the AMT breakeven level. However, this annual AMT breakeven benefit is “use it or lose it.” You cannot roll it over for next year.

Suppose the FMV of your ISO is higher than your exercise price. This strategy could help you stay within a reasonable budget and start the one-year holding period on shares for favorable long-term capital gains tax treatment.

Exercise ISOs during high-income years.

The AMT breakeven point will likely be much higher if you have a significant windfall year. Let’s say you received a large bonus, sold your startup, or hit the jackpot. You will most likely be able to exercise a higher number of ISOs before you reach the AMT exemption.

Exercise NSOs to fill in your tax bracket.

Unlike ISOs, non-qualified stock options (NSOs) are subject to Federal, payroll, and state income taxes. Exercising a big chunk of non-qualified stock options can easily throw you in a higher tax bracket. In high-income tax states like California, your total payable tax can exceed 50%. You will end up keeping only half of your gains.

Depending on your tax situation, you can consider exercising just enough NSOs to keep you within your desirable tax bracket.

Use AMT credit by exercising NSOs or receiving RSUs

Once you pay AMT, you receive a tax credit, which will be payable to you in future tax years. Most people recoup their AMT taxes, but the exact timing depends on your specific circumstances.

You may have the entire suite of grants ISOs, NSOs, and RSU through your current employer or previous startups. If you have exercised ISOs in the past, you may have an outstanding AMT credit.

In that scenario, your AMT credits can offset the taxes you must pay for exercising NSOs or receiving RSU grants.

Exercise ISOs and NSOs with a low bargain element.

If you have recently received ISO and NSO grants, there is a good chance that the fair market value of your unexercised grants will be equal to or closer to the original exercise price. By exercising these specific lots with a small spread between FMV and exercise price, you may have a low to no bargain element. In that scenario, you may not owe any taxes. The downside of this strategy is that for more mature startups with appreciated FMV, exercising newer grants may require a higher cash expense.

Spread an exercise window across two tax years.

If your exercise window stretches between two calendar years, you can decide how much to exercise each year. Again, depending on your specific tax situation in the current and the following year, you can exercise a portion of ISOs and NSOs in December and then another lot in January.

83b election

83b election allows startup employees to exercise their stock options and other equity grants early and pay income taxes based on the Fair Market Value at the time of the election. You must file a one-page form to the IRS declaring your early exercise decision. The election entails that you exercise your ISOs and NSOs before they start vesting. Your primary benefit would be to avoid paying taxes on the growing spread between fair market value and exercise. If your exercise cost and FMV match at the time of your 83b election, you will avoid paying AMT on ISOs and income taxes on your NSOs. The downside is that you will be fully invested in your startup and need to put in upfront capital.

Prioritize long-term capital over short-term capital gains

Long-term capital gains receive favorable tax treatment. They are subject to a 15% or 20% tax rate. On the other hand, short-term capital gains trigger ordinary income tax, which is generally higher. You could pay over 50% in taxes in high-income states like California.

All else equal, prioritizing long-term capital gains can significantly impact your final outcome.

The moment when you exercise your NSOs and ISOs or receive your RSUs, and ESPP shares sets the clock on your holding period.

Each grant has different rules that make them eligible for long-term capital gains.

  • ISOs – 1 year from the exercise date and two years from the grant date
  • NSOs – 1 year from the exercise date
  • RSUs – 1 year from the vesting date
  • ESPP shares – 1 year from the purchase date and two years from the grant (offering) date

Tax-loss harvesting

Tax-loss harvesting is a strategy that aims to realize a loss on a position in your investment portfolio. You can use the proceeds to invest in similar security. However, when it comes time to pay your taxes, you can offset any gains from selling your company shares with realized losses from your tax-loss harvesting strategy. In addition, if your losses are bigger than your gains, you can use the remaining amount to offset up to $3,000 of your ordinary taxable income.

Let’s take an example:

You own 1,000 shares of company XYZ, which you acquired for $100 per share. The total cost basis is $100,000.

In addition to that, you own 10,000 shares from your employer ABC. The cost basis per share is $5

One year later, the price of XYZ dropped from $100 to $75, while the price of your employer shares is $20. You want to sell 2,000 of your company shares, but you want to avoid paying hefty taxes. If you sell your shares, your capital gain will be $30,000. You noticed that your XYX shares have dropped, and if you sell them, you will realize a loss of $25,000. Instead of paying capital gain taxes on $30k, you will only pay taxes on a 5k gain.

ABC capital gain

2,000 shares x ($20 – $5) = $30,000

XYZ capital loss

1,000 shares x ($75 – $100) = -$25,000

Total gain = $30,000 – 25,000 = $5,000

Don’t ignore the tax man

April 15 is the conventional deadline for tax filing. However, the IRS expects you to pay at least 90 percent of your estimated tax liability upfront. If you exercise your shares throughout the year are responsible for paying your taxes, including your AMT. There are four quarterly deadlines for making estimated payments in four equal amounts.

  • 1st payment …………….. April 15
  • 2nd payment ……………. June 15
  • 3rd payment …………….. September 15
  • 4th payment …………….. January 15

You might be subject to penalties if you owe a sizable amount and wait to pay it during the tax season.

Have a comprehensive plan.

The tax implications of exercising stock options can be complex. And there is little room for error. Through my years of experience helping my clients, I can share that the best strategy for you is to have a comprehensive plan. Before exercising your ISOs and NSOs, you must have a holistic view. There are many moving parts with any strategy. The most challenging part is predicting the future fair market value or exit price. Some of our clients have multiple grants from different companies,  various sources of income, or a high-earning spouse. Any additional layer of complexity can dramatically change your assumptions.

About Stoyan Panayotov

I am a fee-only financial advisor and the founder of Babylon Wealth Management. As fiduciary advisors, we provide bespoke wealth management and personalized financial planning to busy families in the Bay Area and nationally. Many of our clients are tech workers, physicians, business owners, professionals preparing for retirement and young families looking to build financial independence.

I started Babylon Wealth Management to help young families and successful professionals build, grow and preserve their wealth. Being a fee-only financial advisor, I never earn sales commissions or sell investment products. Furthermore, I am committed to acting in my clients’ best interest by providing trusted advice and bespoke wealth management solutions. I enjoy helping clients develop robust and personalized long-term financial plans to achieve their personal and financial goals.

After completing a bachelor’s degree in Accounting at Varna University of Economics in Bulgaria, at the age of 23, I moved to New York City to pursue a Master of Business Administration at Pace University. I was fortunate enough to have a full merit-based scholarship and finished graduate school with no student loans. Upon completing grad school, I joined the ranks on Wall Street for nearly two years. I specialized in risk management and option strategies for equity and fixed income products for Deutsche Bank and Wells Fargo. In 2006 I obtained a highly recognized CFA designation.

Living in New York without family support was a life-changing experience for me. II arrived at JFK Airport on August 24, 2002. I stayed in a hostel for two weeks and later moved in with three of my fellow Bulgarian students into a one-bedroom apartment in the Bronx. There was a time in life when all I owned was $200, just enough to pay for the next month’s rent. Many times, I contemplated returning to Bulgaria, but somehow, I always pushed through life’s adversities. I’ve learned to appreciate each moment, big or small, that life presents. These challenges have helped me develop strength and flexibility, which supports my practice as a financial advisor.

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