By Daniel Trumbower, CFP
Congratulations! During a recent promotion or employment change, you were awarded with Incentive Stock Options (ISOs). This new compensation arrangement sure looks great on paper, but if you don’t know how to properly monetize your ISOs, it can get rather messy.
Here’s what to do—and when!—so you don’t miss out on any lucrative (or conversely, costly) opportunities.
First, let’s go over the difference between Non-qualified Stock Options (NQs) and ISOs, and what triggers tax costs.
A key difference between NQs and ISOs is their tax treatment. When you exercise NQs, your company withholds income taxes (Federal, State, Social Security, and Medicare) on the “spread,” or the difference between the exercise price and market price multiplied by the number of options exercised. This is taxed as ordinary income.
However, the taxation structure on ISOs can result in a lower total tax bill compared to NQs. That’s because after you exercise an ISO, if you hold the acquired shares long enough to meet qualifying disposition requirements, the ensuing sale will be taxed as a capital gain rather than ordinary income—potentially saving you a significant amount in tax. Plus, if you finance the exercise cost with cash or via a “stock swap,” there are no immediate tax consequences.
How to Exercise Your ISOs with a Stock Swap
1. Understand Your Plan Documents
First things first— Understand your plan documents, every company is different. Pay close attention to trading restrictions such as “blackout periods.”
There will be several methods available to exercise your ISOs. You need to make sure to know which ones your company allows and evaluate these carefully with the help of a qualified advisor.
Then, make sure you and your advisor are coordinating ISO exercises with your CPA. While no income tax is due at the time of exercise, the alternative minimum tax (or “AMT”) will likely come back to haunt you without a coordinated strategy.
2. Maximizing Value
Let’s assume that your company’s prospects are bright and you are bullish on the stock. In order to maximize the value of your ISOs, you may consider exercising the options and holding the shares. If you hold your shares for at least two years from the grant date and one year from the exercise date, the shares now meet “qualifying disposition” requirements. Once this occurs, you can sell your shares at the preferential long-term capital gains rate rather than paying taxes at short-term rates. The delta between these two tax rates can be substantial depending on your income level, and this is where the true potential value of your ISOs can and should be unlocked.
3. Covering the Cost of the Exercise
How will you finance the cost of the exercise? Your cash flow position or the opportunity cost of generating cash from other investments will weigh into this decision. Of course, you could simply complete a “sell-to-cover” transaction, where a portion of the ISOs are immediately sold to cover the exercise cost of the remaining options that will convert to shares. The shares sold during this transaction are treated similarly to NQs for tax purposes. What if you already own shares of your company stock? If your plan allows it, you might consider exchanging the equity in your shares to cover the cost of the ISO exercise. This is more commonly known as a “stock swap.”
There is no cash outlay in a stock swap exercise, which is wonderful for just about anyone. You have the ability to leverage the fair market value of the shares you already own to cover the exercise cost, and also defer recognizing any capital gains on those shares used in the exchange. Finally, by exchanging existing shares to cover the exercise cost, you are indirectly reducing your total exposure to the company, which accomplishes diversification objectives for those who own a concentrated position.
ISO Stock Swap Example
Let’s examine an example of how a stock swap would play out. This assumes that you already own shares of your company stock in long-term gain status. The current market price of your company stock is $50 a share.
This example would require a swap of 200 of your long-term shares ($10,000 exercise cost/$50 stock price) to finance the exercise. As the end result of this transaction, you retain your 200 original shares (holding period and cost basis carries over) and also receive 800 new shares with a cost basis of $0.
Stop Before You SWAP!
Before engaging in a stock swap, make sure that you and your advisor identify the correct type of shares and specific tax lots that would be suitable for use in the exchange. You could unknowingly trigger a separate tax event by swapping shares previously acquired via ISO exercise or ESPP.
About the Author: Daniel Trumbower, CFP®
Dan Trumbower, CFP® is a Senior Wealth Advisor at Halpern Financial, a fee-only, independent, fiduciary wealth management firm in Rockville, MD and Ashburn, VA. Dan received a BSBA in Finance from Coastal Carolina University, and is a CFP® professional and has special expertise in financial issues affecting key executives of large corporations (such as restricted stock awards, Incentive and NQ stock options along with NUA distributions from employer savings plans).