Exercising incentive stock options can feel like a maze of competing tradeoffs. How bad is the Alternative Minimum Tax? Do I have adequate cash on hand to exercise? Are we creating a concentration problem by owning too much company stock?
With such a web of financial implications, my suggestion is to lean in to the moves that increase your optionality. Here are 3 reasons why focusing on ISO exercise in January are the best moves for your optionality.
#1 - Taxes & Visibility
Exercising an ISO in January gives you the longest possible time between exercise and taxes owed. This is special for a few reasons:
- Any AMT due is not actually payable until the following year’s tax deadline, usually 15 months away.
- You have plenty of time to review & prepare for any AMT owed.
- You create the possibility of a qualifying disposition, which is a sale of exercised stock one year after the date of exercise. Qualifying dispositions are eligible for long-term capital gains treatment on the difference in the sale price vs. FMV at time of exercise.
- This can be utilized in a “sell-to-cover” strategy in which you sell enough shares to pay your tax bill.
Note that you do need to be acutely aware of any underpayment penalties based on last year’s tax return.
#2 - Opportunity to Sell in the Same Year for a Disqualifying Disposition
Ideally, your company’s stock price goes up. All the time. Sadly, we know this isn’t going to be the case every year, on every lot of exercised ISO.
Let’s say your stock price tanks between January and December, and you’ve exercised a big chunk of ISOs in January. Feels bad, right? We wanted to exercise at the lows to minimize the tax bill.
For ISOs, all is not lost, because you thought ahead. If your share price goes down from the time of exercise and you sell in that same year in a disqualifying disposition, your taxes are based on the lower price at which you sold - not the higher January price at which you exercised.
This move functionally swaps AMT on your bargain element for regular income tax rates on your sale price minus exercise cost. You get to divest, skip the AMT complexities, and hopefully rebalance and diversify, without paying any “penalty” for having exercised in January.
This is a suboptimal outcome in a couple of ways, but considering the constraints of “knowing what we don’t know”, this is an important piece of optionality.
#3 - Trading Windows
Related to #1 - exercising in January is the scenario that lets you take advantage of the maximum possible days of non-blackout trading windows.
In addition to this, if your intention is to wait until you’re in line for a qualifying disposition (1 year after exercise), this maximizes your potential to trade in a trading window next year, before your AMT is payable.
ISOs have a lot of funky issues with them. Exercising them early, whether using an 83(b) or just getting it done in January, can have huge benefits. Reach out if you have questions on this topic.