ISOs can give you a nice tax treatment.
How? If you exercise an ISO and hold the share for at least a year before you sell it, then you will pay a lower tax rate than if you had instead:
- Done the same thing with an NSO, or
- Exercised an ISO and sold the share in under one year.
This fact means that most people (including us financial planners) generally recommend that you exercise ISOs and then hold the stock for at least a year before selling it. This is the only way you get access to those sweet, sweet tax bennies.
If the exercise price is really low (let’s say 10¢), that strategy often makes sense because you’re not putting much money at risk when you exercise the stock. But if the exercise price is substantial (let’s say $8, more on that price later), then maybe it doesn’t.
In other words, sometimes it makes every bit of sense to treat ISOs just as you would an NSO: exercise and sell ASAP. Don’t try to take advantage of the tax benefits.
Note: For the most part, this discussion applies to options in a public company. You can sell shares in a public company on the stock market, no problem. Selling shares in a private company, if even allowed by your company, is far more complicated and more expensive, because the private market is far less transparent and efficient.
Also note: Not many public companies award new ISOs, so in practice, this blog post is for people who worked at a company when it was private, were awarded ISOs at that time, the company has since gone public, and you still have exercisable ISOs.
ISOs Reward “Exercise-and-Hold,” Unlike NSOs
So that my comments later in the blog post make sense to you, let’s make sure we all understand how ISOs work.
Let’s say:
- You exercise an ISO. You have to pay the exercise price, $8. The price at the time of exercise is $10.
- When you exercise an ISO, you can avoid any sort of tax liability by exercising few enough to stay under the Alternative Minimum Tax (AMT) threshold. So, let’s say you exercise few enough, and so all you pay upon exercise is the exercise price.
- After a full year, you sell the stock for $14, and all the gain from the exercise price to the sale price ($6) is taxed as long-term capital gains (which is generally a lower tax rate than your “ordinary” income tax rate).
By contrast, non-qualified stock options (NSOs) operate this way:
- You exercise an NSO. You have to pay the exercise price, $8.
- The moment you exercise the option, you owe ordinary income tax on the gain from the exercise price to the current price of the stock ($10). So, you owe ordinary income tax on $2.
- Whether you sell the stock immediately or you hold it for 5 days, 5 months, or 5 years doesn’t affect the fact that you owed taxes the moment you exercised.
- If you sell it immediately, you pay no more tax.
- If you sell the stock after a full year for $14, then you own long-term capital gains tax on $14-$10 = $4.
So you can see that, handled correctly, ISOs will subject all of the gain above your exercise price to the lower long-term capital gains tax rate. NSOs will subject some of the gain above your exercise price to ordinary income tax and the rest to the lower long-term capital gains tax rate.
All else equal, we’d rather have all the gain subject to a lower tax rate, which is a vote in favor of ISOs over NSOs.
As for NSOs, my advice is almost always: Exercise and sell ASAP. There is no tax benefit to exercise and holding. The only reason to hold on to the shares would be your faith that the company stock price will increase. And if that’s the case, then you might as well hold on to the options, because as long as you hold the option, you’re not putting any money at risk and you’re still participating in the possible upside of the stock. You can see my thoughts about when I think is an appropriate time to exercise (and sell) your NSOs.
Yet You Might Still Want to Exercise and Sell Immediately.
When you exercise options, you pay two costs:
- The exercise price
- Taxes you pay on the exercise
If the stock price continues to rise after you exercise, great! You have a positive return on that investment cost. If the stock price falls, however, you can end up losing money, even if you get a lower tax rate because it’s the fancy kind of option (aka, ISO).
You can avoid taxes entirely with ISOs, if you plan it well enough. (I recommend working with a CPA to figure this out.) For the sake of simplicity, let’s assume going forward that there is no tax bill upon exercise.
If the exercise price is only 10¢, and you have 20,000 ISOs, heck, the price to exercise them all is only $2000. Which, for most people I work with, is money they can afford to lose.
But…
What if the exercise price is $8, as it is for a client of mine whose company recently went public and she has a bunch of these lovely ISOs at that exercise price?
Exercising all her ISOs, even if we assume no taxes, will cost her $160,000.
Uh…I work with some high-income and/or high-wealth people, and I don’t think any of them thinks “$160k? Pshaw. Pocket change.”
So, this client has decided, for now at least, to not exercise any of her ISOs. She’s going to work her way through her NSOs (exercising and selling ASAP), and each year we’ll reevaluate whether she wants to put any money at risk by exercising and holding her ISOs.
If we use up all of her NSOs and the client still doesn’t want to risk any of her existing wealth on exercising and holding the ISOs? Then we’re just going to treat them exactly as we have the NSOs: exercise and sell ASAP.
Will she pay a higher tax rate? YES
Will she eliminate any risk of losing money? ALSO YES
Has she considered and is she fine with that trade off? ALSO ALSO YES
Am I fine with that trade off, as her planner who only wants what’s best for my client? YES. In fact, I think it’s highly rational.
So if you have ISOs, and you know all about how awesome they are tax-wise…that doesn’t mean you have to take advantage of their better tax treatment. You could completely ignore their tax benefits (by selling right after exercising) and still be confident that you made a rational, pragmatic decision.
Do you want to feel more confident about the choices you’re making with your stock options?
