Follow up Tax Bomb from Exercising NQSO’s
As a follow-up to my last blog about the large tax implications from exercising nonqualified stock options (NQSOs), let’s look at converting the bargain element of incentive stock options (ISOs) into long-term capital gains.
Except in rare situations, exercising ISOs will produce the same or better tax result, taking AMT (alternative minimum tax) into account.
Here are the tax benefits for ISO holders:
- At the time the options are exercised, there is no regular income tax.
- If the shares are held long enough to avoid a disqualifying disposition1, any profit from the exercise will be taxed as long-term capital gain.
- The bargain element from exercising ISOs or selling shares later is not subject to income tax withholding or social security tax.
An option holder who exercises ISOs and holds the shares for a year or more after exercising them will be subject to AMT on the bargain element regardless of the stock price.
Obviously, the risk associated with ISOs is being subject to AMT in the calendar year of exercise, then holding the shares beyond the calendar year in which they were exercised to obtain the long-term capital gain rate—only to see the stock drop before the one-year holding period ends. As mentioned in an earlier blog, one way to reduce the risk is to reduce the holding period in the year after exercise, i.e., exercise ISOs early in the year so shares can be sold by December 31 to eliminate the AMT liability.
Dan’s Moral: Timing is everything when exercising ISOs, then holding and selling shares to reduce the tax liability by more than 50%.
1Disqualify disposition: In order for the option holder to avoid a disqualifying disposition they must meet both of the following requirements:
- No disposition within two years of grant date;
- No disposition within one year after the shares are transferred (exercised).
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