For most people stock options are an addition to their base compensation and an opportunity to profit if the company does well. Yet each year, it is estimated that more than 10% of in-the-money options expire unexercised. Some other mistakes options owners make include selling vested shares early and missing out on future appreciation, not taking action to protect gains when options have appreciated in value, waiting until the last minute and exercising options at expiration, failing to plan for taxes until they are due, and not considering risk and portfolio diversification issues. We will help you manage your stock options most effectively.
First thing first. There are two kinds of stock options that have different rules and tax issues: incentive stock options (ISO) and non-qualified stock options (NSO). Before implementing any it is important to understand how ISO and NSO are taxed.
Under an ISO, there is no tax liability when you exercise the options and hold the stock, until you actually sell the stock or make a non-sale disqualifying disposition. When you sell the stock, the difference between the amount you paid and the amount you receive from the sale is taxed as capital gains income (or loss). To qualify for long-term capital gains treatment, you must hold ISO shares for at least one year and a day from the date of exercise. If you sell the shares in less than 12 months you will have taxable ordinary income, which is subject to federal, state, local and social security taxes. The taxable amount (or loss) is generally measured by the difference between the fair market value on the exercise date and the option price. However, the exercise of an ISO can trigger the alternative minimum tax (AMT).
When you exercise an NSO, you can be subject to taxes on two occasions: at time of exercise and again at the sale of the stock. Any gain at the time of exercise is taxed as ordinary income. If you hold the stock and sell it at some point in the future, you would pay capital gains tax on any additional appreciation (meaning any appreciation of the stock from the price at exercise). It is important to remember that long-term capital gains treatment only applies if the stock is held for more than one year from the date of exercise.
Here are some strategies to consider if you are have stock options:
- A cashless exercise in which vested options are exercised at a predefined price or expiration. With a cashless exercise there is no out of pocket cost. The options are exercised and the shares are sold immediately. The net proceeds (market price less the cost of the option, transaction fees and taxes) are deposited in your account several days later.
- A cashless hold is when you exercise enough options to purchase the remaining shares without using additional cash. In this strategy, you simultaneously exercise and sell enough stock to cover the cost of exercising the options (and taxes). You receive the remaining shares and any fractional shares will be paid in cash.
- Setting up a plan to track the price of the underlying stock and systematically exercising vested in-the-money options prior to expiration or at a set target price to capture the gain. If the stock price continues to increase, continue exercising additional options. This is a situation where you do not want taxes to drive your decision. You may be better off exercising the options and moving the stock to a brokerage account where you can place stop orders to protect your gain if the stock’s price suddenly plunges. Keep in mind that if the price of the stock plunges and the options were left unexercised, you would have had no gain.
- Timing the exercise of options to help manage taxes. Most companies withhold some taxes when options are exercised. However, that may not be enough to cover your full tax liability. If options are exercised in January, February or March, the stock can be held for 12 months, allowing the shares to be sold and receive capital gains tax treatment, and then sold in the next calendar year to help cover any taxes due. For example, exercise options in February of 2016 and then sell the shares in March of 2017. The 2016 taxes from the initial exercise are not due until April of 2017. If you use this strategy, be sure to place stop orders in case the stock drops in price. Granted, any gain will be taxed as ordinary income, but you will not have to come up with other funds to cover your tax obligation.
- If the plan allows, consider a stock swap. In this strategy, the option exercise is funded using company stock you already own. A stock swap is a tax-deferred exchange. You surrender enough shares of stock to equal the exercise price of the options you plan to exercise. The cost basis and holding period in the old shares carry over to the new shares. Any additional bargain element would be taxable income. This avoids any tax liability on the unrealized appreciation in the old shares, until the stock is ultimately sold. It also will provide the funds to exercise the options without having to tie up additional capital.
- If you expect the company stock to significantly appreciate in value, make an 83(b) election. In this strategy, you exercise the options prior to vesting. The bargain element is taxed as if the options were vested. Once the options actually vest and holding period requirements are fulfilled, any gain is taxed at capital gain rates. This can help avoid AMT if the election is made when the bargain element is small. Bear in mind, even though the options have been exercised, the owner has no control until they fully vest, and there is a risk that the stock will not appreciate or drops in value.
- Gift NSOs if the plan allows. The transfer is not considered a completed gift until the options vest, and the donor is liable for any income taxes due on bargain element. This strategy allows you to remove the value of the options from your estate and transfer the future appreciation to others, possibly in a lower tax bracket.
- If you have already exercised ISOs and the price of the underlying stock drops, consider a disqualifying disposition. This disqualifies the ISOs from receiving favorable tax treatment—in essence turning them into NSOs. Options become disqualified after exercising by selling the stock before meeting holding period requirements. In some cases, an intentional disqualifying disposition could be used if ISOs were exercised and then the price of the stock plunged before the shares were sold. The exercise would be taxed as ordinary income avoiding the AMT issue.
The Bottom Line
Options are a great incentive and need to be managed. Depending on your financial situation, employing more than one strategy may be the best approach. And always consider portfolio diversification and reducing risk by not building a concentrated position (more than 5% of your investments) in one stock.