3 ISO tax mistakes and how to avoid them
Avoiding the 3 biggest ISO tax mistakes
As I'm writing this it's April 15th in the US, and tax day is finally here. It only seem appropriate to continue my "Stock Option Basics" series (Part I, Part II) with an overview of ISO tax works and a quick look into a couple of ISO tax situations you DON'T want to get yourself into. Because this is so complex, there's not much hope that I'll be able to fully explore every scenario... make sure to discuss all of this with your tax advisor.
Incentive Stock Option (ISO) Tax Basics
As I covered in Part I, ISOs can potentially be quite lucrative, but as an added bonus they're also taxed significantly more favorably than regular income. Or... they can be depending on when you exercise them. That's the part that can get confusing. Keep in mind I am not a tax attorney or CPA, so please consult a qualified advisor to double check all of this.
At the highest level, qualifying ISO dispositions are taxed in two ways:
- You pay AMT (Alternative Minimum Tax) after exercise on the difference in value between your exercise price and the current fair market value, which is determined by your company if it's not publicly traded. In other words, if your exercise price is $1, and you exercise stock with a fair market value of $10, then the $9 will count as income towards AMT and will be taxed as income at your AMT rate. This IS NOT taken out of your paycheck, so expect a large tax bill when you do this. One caveat: AMT only comes into affect for relatively high earners, so if you only make $30k a year and exercise $10k in stock this may not affect you. ISOs and AMT go hand in hand: it's vital that you understand the relationship to maximize your return and minimize your risk.
- You pay long term capital gains on any gain between the value at exercise ($10 in the example above) and the fair market value at disposition (sale). To get this treatment, you need to own the stock after exercise for at least a year and a day, and you must have been granted the stock at least two years and one day before the sale. In the example above, if you sell the stock a year and a day after you exercise for $20 a share, you will pay long term capital gains on the $10 difference between the sale and exercise price ($20 sale price - $10 exercise price = $10 difference). If you're in the top tax bracket, or close to it, that could be a LOT of extra cash since long term capital gains tops out at 20%, where income taxes can reach close to 40%.
Now, some of you might have noticed that I said QUALIFIED dispositions. If you happen to exercise your stock and sell it in the same calendar year, or otherwise step outside of the guidelines I described above, the difference in value between the exercise price and value at exercise is taxed as income. Any difference between the value at exercise and sale price is taxed as capital gains.
There's a lot more detail to cover, but the bottom line whether it's a qualified disposition or not is that you want the fair market value of the stock at exercise to be as LOW as possible, and preferably very close to the exercise price.
ISO Tax Mistake #1: Exercise high and sell low
Let's say that Eric joined Fungle, Inc. in 2014 and they gave him a nice 10,000 share package at a low $1 exercise price. Then, in 2017, after 3 years of astronomical growth and titanic fundraising rounds he exercises his shares (when Fungle is still private) at a fair market value of $100 per share. On paper, he's almost a millionaire!
A little later, in May 2018, Fungle goes public at $120 a share and Eric looks like an absolute genius for exercising when he did: he has a big bill for the $99 between his exercise price and the FMV at exercise, but he's only going to pay 15% on the $200k difference between his FMV at exercise and the current value. He saved $30k! But... right before his first qualified disposition date on 1/1/2018, the economy suddenly grinds to a halt. Fungle misses their earnings by -120%. Wall street runs for cover. The stock craters. Eric hangs onto his shares as the stock passes $100, then $80, then $60... hoping things will get better. Eric finally sells in February 2018 at $20 a share, desperate to stop the bleeding. The good news? He has $200,000 in the bank ($20 X 10,000 shares). The bad news? He owes $346,000 in taxes. Eric's 5 years of startup sweat and tears earned him -$146,000.
Here's the math: Grant date: 1/1/2014, Exercise date: 1/1/2017, Sale date 2/1/2018, 10,000 shares total vesting over 3 years. Exercise price: $1, Price at Exercise: $100, Price at sale $20.
Alternative minimum tax due from exercise in 2017: $346,000 ($99 * 10,000 = $990,000 * 35% tax rate = $346,000 plus or minus)
Sale price: $200,000 ($20 * 10,000)
Loss: $146,000 ($346,000 - $200,000)
This whole situation is stupid because it could've been avoided in so many ways. First of all, if he really wanted to lock in the low capital gains tax, he should've exercised his shares as he vested them over time, presumably at a price much lower than $100 a share. This also would've considerably eased his AMT tax burden, although he would have had to pay taxes every year he exercised. Second of all, he should've hedged his bets and sold at least enough stock to pay for his tax bill when the price was $120/share. Third, he could've sold everything he had at $60 a share. Yea, he would only have netted a couple hundred thousand dollars, but it would've been so much better than losing $146,000.
Lesson: Play it safe. If your exercise is going to trigger a massive AMT bill, and you can't sell the stock anyway, it's much less risky to wait and (begrudgingly) pay the disqualified disposition regular income tax rate. Better still, hedge your bets and exercise a little over time. Sure, you won't get it "perfect" but you won't get completely hosed either.
ISO Mistake #2: Exercise and wait... and wait...
In this scenario, Beth started work at Grungle in 2014 with a nice 20,000 share package at a $1 exercise price. After four years, Grungle is doing AWESOME and the CEO lets the whole team know that an IPO is imminent. Eager to lock in a low tax rate, and anticipating a large increase in value after the IPO, she exercises her full option package at a FMV of $20 a share, giving her $400,000 (20k*$20) in paper profits and a $140,000 AMT tax bill (see math below). But, the IPO is coming soon, so she figures she'll be able to sell her stock by the time her taxes are due.
But, after some hiccups in the supply chain and some very public customer complaints, Grungle's CEO decides to keep on going as a private company for at least the next two years. Beth owes $140,000 in very real taxes, but all she has to pay it with is illiquid Grungle stock of dubious and unclear value.
Here's the math: Grant date: 1/1/2015, Exercise date: 1/1/2019, Sale date ???, 20,000 shares total vesting over 4 years. Exercise price: $1, Price at Exercise: $20
Alternative minimum tax due from exercise in 2017: $70,000 ($20 * 20,000 = $400,000 * 35% tax rate = $140,000 plus or minus)
Lesson: Don't saddle yourself with a tax bill that you can't pay, or with stock that you don't know when you'll be able to sell.
ISO Tax Mistake #3: Miss the exercise boat
I know, the first two scenarios are pretty similar, but scenario 3 is pretty much the polar opposite. I'll use a more real life example here.
Varun starts at Google on 1/1/2001, before it's even a thing. He gets 200,000 shares at $0.50 a share, vesting over 4 years with a 1 year cliff. On 1/1/2002, his first 50,000 shares vest, and the board sets the value of the stock at $1 per share, effectively doubling the value of his grant. This means that he'll need to come up with $25,000 to exercise his stock, and another $10,000 (+-) to pay his AMT. I'm assuming you get the math by now so I'm not going to spell it out. Unfortunately, he doesn't have that kind of money lying around, and he doesn't want to borrow it, so he decides to play it safe and not exercise.
In 2003, he's got a little more money saved aside, but the board sets the value of the stock at $5 a share. This means that he's going to need to come up with $50,000 to exercise, and then at least $150,000 for AMT. Again, he doesn't have the money so he waits.
In 2005, Google goes public for $50 a share. Varun has $10,000,000 in stock, and finally he exercises. But, he pays AMT on every single nickel of his $10,000,000. Even if he had only exercised his first 50,000 shares in 2002, and exercised the rest at IPO, he still would've saved close to a million dollars.
Lesson: If you have the opportunity to exercise at a low price, and with a reasonable AMT bill, do it. Don't have enough money to exercise everything? Then exercise the amount you feel comfortable with.
It's easy to get worked up about taxes with ISOs, but at the end of the day its pretty straightforward. As always, it's important to have a visual representation of what has currently vested and what WILL vest in the future, as you see above. I use Personal Capital as a free tool to do this, but you can also keep track of it manually if you are a glutton for punishment.
Once you know where you stand, it's all about current FMV. If you can't exercise at a low FMV price, then it's probably better to play it safe and JUST WAIT, even though you'll probably pay higher taxes in the long run. The same is true if liquidity is a long way away. On the flipside, if you can exercise at a low price without incurring life-changing AMT (and you have confidence in your company), then exercise as much as you feel comfortable with.
The bottom line is that you shouldn't let the tail wag the dog: don't put yourself in Eric's position because you want to save 5-10% on your taxes. Try to sensibly, methodically exercise what you feel comfortable with a little bit at a time. When the price gets too high, wait out the IPO and pay your taxes as they come.