In the case of incentive stock options (ISOs), the timing can be even more critical. In fact, if you don’t plan carefully, you could easily increase the taxes you owe or find yourself with a hefty tax bill and no cash from the ISO shares to fund it.
However, if you exercise your ISOs before April 15th, you could significantly enhance your cash flow and possibly even reduce your federal tax bill. To understand why, let’s start with a little basic background on ISOs.
An ISO is one type of stock option that can be granted to a company’s employees. This type of stock option can provide significant advantages over others, including nonqualified options.
ISOs do not generate regular taxable income to you when exercise the options, only when you sell the stock. The taxable income at sale is equal to your gain — in other words, the difference between the amount you had to pay for the shares (your basis) and their fair market value.
The resulting taxable income can qualify for treatment as long-term capital gain rather than ordinary income, as long as you hold the stock long enough. Unlike nonqualified options, if you’ve satisfied the special holding period, the income is not considered compensation and therefore is not subject to Social Security taxes.
Now for the downside: You may find yourself subject to alternative minimum tax (AMT). When you exercise your options, the difference between the price you pay for the shares and their fair market value becomes one part of the alternative minimum tax AMT calculation and may be enough to subject you to this additional tax.
The AMT you owe, if any, is due for the tax year that you exercise the option, whether or not you’ve sold any of the shares. So you could find yourself with a hefty tax bill and no cash to pay it. On the plus side, some or all of your AMT liability may generate an AMT credit that reduces your regular tax liability in future tax years when you are not subject to AMT. Also, the amount of the AMT adjustment increases your basis in the stock for future AMT calculations.
So why does the timing of your exercise matter? Let’s assume you intend to exercise options this year and you’ll need to sell a portion of the resulting shares to pay the tax liability. The AMT calculation is performed for your 2007 tax return, filed in 2008. Ignoring any estimated tax considerations, the tax won’t be due until April 15, 2008.
If you exercise before April 15th the shares you receive upon exercise will qualify for capital gain treatment by the time your 2007 tax return is due. You can sell them to fund your AMT liability.
If you exercise the options after April 15th, you’ll have to hold the shares until after April 15th of 2008 to meet the special holding period requirement for ISOs. That means you can’t sell the shares to provide cash for your AMT liability without sacrificing the beneficial ISO tax treatment. In other words, if you don’t own them long enough to satisfy the special holding period, you’ve made what is known a disqualifying disposition. Your gain will be taxed as compensation at the higher ordinary income tax rates. Interestingly, there is one time when a disqualifying disposition is actually beneficial: when the stock price has decreased dramatically.
The cash-flow impact of exercising before, rather than after, April 15th in any tax year can be significant — as illustrated in the simple example below. Both scenarios assume you hold the stock long enough to qualify for ISO and long-term capital gain treatment. Under the first scenario, where you exercise before April 15th, you can sell your ISO shares in time to pay the AMT due with your tax return and the sale of the stock is sheltered by the AMT credit. Under the second scenario, you have to fund the tax liability without selling the new shares.
The tax rules regarding stock options are exceedingly detailed and complex, and each person’s tax situation is unique — for example, you might have a cashless exercise option in your plan or already own stock you have held for more than one year. As a result, you’ll want a more detailed analysis and advice to understand the financial and tax impacts, as well as any windows or other restrictions that govern when you can exercise your options.