When Intentionally Disqualifying ISOs at Year End May Make S…

Deciding when to exercise, hold, and sell your incentive stock options (ISOs) is complicated, requiring you to manage several simultaneous financial variables, all at the same time. These include:

• Prices: Especially the strike price, the share price at exercise, and the final sale price
• Tax-Efficiency: Whether to make a more tax-efficient qualified sale (while maintaining single stock risk), or a faster disqualified sale.
• AMT Management: How to manage alternative minimum tax (AMT) due if you exercise and hold

That’s a lot to tend to, and things become more complicated post exercise and hold. As the stock price changes, your opinion as to whether exercising and holding ISOs was a good idea may change. In fact, if the stock price is lower post exercise, you may reconsider whether you’re better off holding ISO shares for a qualified sale in hopes of paying long-term capital gains (LTCGs), or selling them in a disqualified sale and incurring less favorable ordinary income tax.

But why would you want to intentionally disqualify ISOs and pay ordinary income tax? And when might it make sense to do so? Let’s explore:

Why You Want to Exercise ISOs Early in the Year

There are several reasons employees might choose to exercise their ISOs early in the calendar year, and then sell the stock at least a full year and a day later in a qualified sale. By exercising early one year and selling just over a year later, you’ll achieve a more tax-efficient qualified sale. Plus, by timing it in this manner, you can plan to use the proceeds of the final sale to pay the AMT due on the exercise and hold.

However, what about that share price while you’re holding the stock? Exercising early in the year and waiting for a qualified sale works well when the final sales price is equal to or greater than the price at exercise. But if the share price goes down while you wait, you may regret exercising and holding the shares when you did—especially if you end up owing AMT on “phantom” stock values that existed at exercise but are no longer there when you sell the stock.

Fortunately, not all hope is lost. There’s a second reason to exercise and hold ISOs early in the calendar year: It allows the most time to access an escape hatch from AMT due to the down-market scenario touched on above. Specifically, you may be able to sell your exercised ISO shares prior to year-end. While this disqualifies the ISO, it also eliminates the AMT adjustment that is creating the tax due to begin with.

Still, there’s a bit more to contemplate before you proceed either way. Just because the stock price is below its fair market value (FMV) at exercise does not mean you should always sell the stock and disqualify the shares. Before making a final call, it’s important to consider a few personal factors, as well as how much or little the stock is off from its fair market value at exercise.

Let’s look at why this is so, starting with a review of the ISO exercise and hold.

Reviewing the Basics of an ISO Exercise and Hold

When you exercise and hold incentive stock options past the calendar year-end, you calculate AMT using the ISO’s bargain element. An ISO’s bargain element equals the difference between the ISO’s FMV at exercise and its strike price, multiplied by the number of options you’ve exercised. Generally speaking, the bigger the bargain element, the bigger the potential for AMT.

There’s a reason you may choose to exercise and hold ISOs and take on AMT: It gives you the opportunity to turn what might otherwise be taxed as ordinary income at your marginal tax rate into income taxed at preferential LTCG rates.

However, this requires you to meet the following standards for a qualified disposition.

• The final sale must occur at least a full year from the exercise date of your ISOs.
• AND the final sale must occur more than 2 years from the grant date of your ISOs.

Assuming you do a qualified sale, you’ll pay LTCG tax on the difference between the final sale price and the strike price of the option itself. In addition, if you pay AMT when exercising ISOs, the payment will often be returned to you over time as an AMT credit (the details of which go beyond this article). As such, it’s reasonable to say the AMT is temporary, although it still may represent real dollars coming out of your cash flow when the upfront AMT is due.

Anything other than a qualified sale is disqualified, with nuanced tax ramifications. For our purposes here, we will simplify the calculations by assuming the difference between the final sale price and the strike price is taxed as ordinary income.

Why You May Want to Sell Your Shares Before Year-End in a Disqualified Sale

All else equal, taxpayers prefer LTCG over ordinary income tax rates. However, stretching for this preference may not always be in your best interest when it comes to your ISOs. In fact, as touched on above, if the stock price declines after you exercise and hold your options but before you sell them, your strategy might warrant a change.

Let’s explore this position.

As mentioned above, the bargain element for ISOs is an adjustment for figuring the AMT. The larger the bargain element at exercise, the greater the potential for AMT.

After you exercise, the stock price will continue to fluctuate. If the price increases, you’re good to go when it comes time to sell. But if the stock price declines, you may want to keep an eye on things. If the stock price decreases below the FMV at exercise and you continue to hold the shares past year-end, you might end up paying AMT on “phantom” income. Put another way: If the stock price drops considerably and you wait to sell until after year-end, you may find yourself paying more in AMT than the stock is worth.

To dodge an unpleasant scenario where you’re paying more in AMT than the prevailing price warrants, ISO rules say you can sell your shares prior to year-end as a disqualified sale. By disqualifying the sale, you’ll eliminate the need to report and pay on the bargain element adjustment for AMT. Instead, you may pay ordinary income rates on the spread between the ISO strike price and the final sale price. Let’s illustrate.

Qualified vs. Disqualified Sale Illustrations

Assumptions for a Significant Stock Price Drop After Exercise:

• Total ISOs: 10,000
• Strike Price: $5/share
• FMV at Exercise: $100/share
• Prevailing Market Value: $15/share (an 85% decline from FMV at exercise)
• AMT Rate: 28%
• Ordinary Income Rate: 35%
• LTCG Rate: 20%

Scenario 1 – A Next-Year Qualified Sale: Using these assumptions, if you exercise and hold your ISO shares past the calendar year-end of the exercise, you’ll incur a hypothetical AMT due of $266,000.

• AMT Projection: AMT Due: $266,000
  • [10,000 shares * ($100 – $5)] * 0.28

You’ll also continue to hold the stock, retaining single-stock price volatility while hoping to obtain LTCG tax rates when you sell in the subsequent year. Because the stock price has declined considerably since exercise, the prevailing market value of the shares at a sale past year-end is now only $150,000 ( 10,000 * $15).

At our illustration’s prevailing market value, and assuming a qualified sale, the LTCG tax due will be $20,000.

• Total AMT Due: ($266,000)
• Total Recognized Profit: $100,000
• Total LTCG Tax: ($20,000)
• Net Cash Flow: ($186,000)

In addition, $266,000 of AMT credit is available for future years.

(As an aside, I simplified assumptions about the timing of these events to illustrate a point. The timing of tax due, proceeds of the sale, and AMT credits can vary.)

Scenario 2 – A Same-Year Disqualified Sale: When the value of the stock itself is considerably less than the AMT due, you might ask yourself if holding the stock past year-end to obtain LTCG tax savings remains the best strategy. If not, you may be able to sell your shares as a disqualified sale prior to year-end. Again, this removes the AMT adjustment, avoiding $266,000 of AMT due. But it also realizes typically higher ordinary income tax rates on profits from the final sale.

Assuming a year-end disqualified sale of the same $150,000 prevailing value, we calculate the following.

• Total AMT Due: $0
• Total Profit: $100,000
• Total Tax: $35,000
• Net Cash Flow Current Year: $65,000

Scenario 2 results in a higher ordinary income tax due of $35,000 and no retained shares. However, it also removes single-stock risk, removes the AMT tax due, and results in a positive cash flow for the tax year.

Scenario 1 results in $15,000 less tax due and retains single stock risk. This begs the question: Is a tax savings of $15,000 worth a temporary (but potentially long-term) cash outlay of $266,000?

Comparing Scenarios: Degrees of Difference

When comparing the scenarios just provided, it’s possible you might lean toward selling the stock in a disqualified sale prior to year-end to avoid a big AMT. But this begs the question: Does it always make sense to sell your ISOs if the prevailing price is lower than the FMV at exercise?

For example, what if the prevailing stock price is less than the FMV at exercise … but not by a lot? What if the stock price is only down a little? Does it still make sense to sell your ISO shares in a disqualified sale to mitigate AMT in the current year? Or will incurring the AMT to achieve LTCG tax rates still be preferred (especially if it’s the reason you performed an exercise and hold to begin with)?

As suggested earlier, there may be a tipping point at which a slightly lower stock price may not alter your best-laid LTCG plans after all. Let’s consider this scenario next.

Exploring a Disqualified Sale When the Price is Down

To continue our illustration, what if, instead of experiencing an 85% decline in the stock’s $100 value post-exercise, you encountered a 10% decline in value, with a prevailing market price (and subsequent final sale price) of $90 per share?

In this example, we have the following:

• AMT Projected (Current Year): ($266,000)
• FMV of the Stock: $900,000
• ISO Strike Price: $50,000

Scenario 1 – A Next-Year Qualified Sale: If you held the exercised stock and waited for the LTCG rate, you’d experience the following:

• Current Year AMT: ($266,000)
• Profit on Qualified Sale: $850,000
• LTCG Tax (20%): $170,000

Scenario 2 – A Same-Year Qualified Sale: Option two is to sell the shares prior to year-end, report ordinary income on the difference between the final price and the strike price, and avoid AMT:

• Current Year AMT: $0
• Profit on a Disqualified Sale: $850,000
• Ordinary Income Tax (35%): $297,500

In this example, a temporary AMT of $266,000 may be reasonable if the original (and continued) goal is to hold for LTCG and capture the current $127,500 savings between ordinary income tax and LTCG tax projections. With an $850,000 profit, you also have the cash flow to cover the AMT, which should eventually be recoverable through the AMT credit.

Following this logic, we can illustrate the tax savings opportunities based on various prevailing stock prices.

* OI = Ordinary Income

Some observations from the above chart:

• As the prevailing stock price decreases compared to the FMV at exercise, so does your total profit (i.e., the difference between the stock’s FMV and the option’s strike price).
• As the total profit decreases, so does the benefit of a qualified sale and LTCG tax rates.
• Even if the prevailing stock price decreases compared to the FMV at exercise, the AMT incurred on a qualified sale stays the same. That is, you continue to be responsible for paying AMT on the FMV at exercise (as illustrated in our chart column, “Excess AMT over Current Value”). This “phantom” AMT income is potentially punitive, subject to several individual factors.

Finding the Tipping Point Between a Year-End Sale or Hold

How low does the stock price need to go before it starts making sense to sell your shares and intentionally disqualify the stock, to eliminate the AMT payment?  Here are some directional planning thoughts to consider:

• If the prevailing stock price is at or near the FMV at exercise: The AMT projected at exercise is expected, which may justify continuing to hold the stock for LGTC treatment. After all, this was part of the plan to begin with.
• If the prevailing stock price is considerably lower than the FMV at exercise: It’s more likely you’ll want to sell the stock as a disqualified sale, as the benefit of LTCG treatment may be outweighed by the cash flow necessary to pay AMT.
• If the prevailing price is somewhere in between: The decision becomes most difficult. Does it make more sense to sell and transition to ordinary income? Or does it make more sense to pay AMT, continue to hold the stock, and sell later as a long-term capital gain? A chart like the one above, applied to your own situation, may help you weigh where you’re at.
• If there is $0 or minimal AMT due from an exercise and hold: In the above scenario, we assumed a big AMT due. However, if you project $0 AMT due, continuing to hold the stock for LTCG (even if it’s down), may make the most sense, particularly if you are bullish on the stock.

Beyond these rules of thumb, it’s important to consider several personal factors—such as your individual financial plans, investment goals, tax status, total income, willingness and ability to endure stock concentration risk, cash flow needs, and more.

Thus, it can be extremely difficult to decide what is the right move. I recommend you consult a professional to help you examine your literal and figurative options. As is so often the case in life, the best answer to when to sell your exercised ISOs is: It depends.

This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.