Early Year Exercise of ISO Strategy
As I had indicated in my November 2010 blog, it is normally preferable to exercise ISO shares early in the year to start the one-year holding period to qualify for the long-term capital gain rate.
This blog will explain the reason behind the early exercise and the impact on AMT (alternative minimum tax). The primary advantage provided by ISO shares is the ability to have the bargain element (gain upon exercise) taxed as a long-term capital gain instead of as ordinary income.
Currently, the long-term capital gain rate is less than half of the top marginal tax rate, so the tax savings is substantial. In order to be eligible for the ISOs to be taxed at a long-term capital gain rate, the option holder must meet both of these requirements:
- No disposition occurs within two years from the option grant date.
- No disposition occurs within one year from when the option is exercised and transferred to the option holder.
When these two criteria are met, the bargain element is taxed as a long-term capital gain. This special holding period is often referred to as a qualifying sale.
The second requirement—shares from exercise must be held for a year—is challenging. The bargain element is subject to AMT in the calendar year of exercise. If the value of the shares was to drop substantially before the one-year holding period ends, the option holder may own shares that are worth less than the AMT tax liability. There lies the rub.
The question becomes: “How do I obtain a long-term capital gain rate after exercising my ISO shares without the added risk of the shares going down?” The answer is: “Exercise ISO shares as early in the calendar year as possible.” The tax code indicates that if ISO shares are sold before the end of the calendar year in the year of exercise, the bargain element would be subject to ordinary income and the AMT would be eliminated.
By exercising ISOs early in the year (January, February), the exposure of the stock dropping substantially to meet the one-year holding period is only a month or two versus six months or longer for ISOs exercised in June or beyond.
Dan’s Moral: The early ISO exerciser gets a head start on the special holding period and is ahead of the game.
Daniel Langworthy does not provide tax advice. Please consult a qualified tax advisor.
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