ISO Exercise Strategies for Texans

Chris Reddick |

Increasingly tech start-up companies are moving to Texas to take advantage of lower taxes and a more favorable business climate. With these moves, high-tech workers are being offered Incentive Stock Options (ISOs) as part of their employment agreement. Typically, these come with a four-year vesting schedule where you get a quarter of the options vested and exercisable each year.

The ISOs are typically granted at a low price, and by the time they are vested, the value could increase dramatically.

There are three several strategies that you should consider when exercising your ISOs. Be sure to talk to your tax advisor and/or financial planner before exercising any of these strategies.

1. Exercise, Hold and Sell After a Specified Period. This strategy is commonly used to take advantage of long-term capital gains in the bargain element, which is the difference between the strike price and FMV when the stock is sold. But to take advantage of this, the ISO must be held two years from when it was granted to you and one year from exercise. This is called a qualified disposition, according to the IRS. The long-term capital gains rate is usually much lower than your ordinary income tax rate. The drawback of this approach is that you have to come up with the money to purchase the ISOs at the grant price. Another big disadvantage is that the bargain element is potentially subject to the Alternative Minimum Tax (AMT).

2. Exercise and Sell Immediately. Another common strategy is to exercise your options after they are granted and then sell them immediately. The benefit of this is that you can profit from the ISOs, assuming they are exercised at a greater value than what you were granted. The drawback is that you would have to pay ordinary income tax on the bargain element, so no long-term capital gains.

3. Exercise and Hold. The last option is to hold them beyond the one year from exercise and two years from grant. The benefit here is that after your company goes IPO, there could be a significant rise in the stock value, and you could make a decision in the future when you want to sell your shares. The drawback is that when companies go IPO, the stock value can be very unpredictable, which can pose a significant risk of having too much of your savings in a single stock.

There are, of course, other options such as early exercise that work as well. The type of strategy that you employ is dependent upon your needs. For instance, if you want to pay off debts or get a downpayment on a mortgage, it might make sense to exercise the ISOs immediately after they vest. You would potentially pay more in taxes but be able to do other things immediately with the money.

Or, if you don’t have significant debts but are in a high tax bracket, you might want to exercise and hold to take advantage of long-term capital gains. But, again, the potential long-term benefit of the much lower tax rate is substantial and should be seriously considered.

But, again, be sure to talk to your financial planner about what works best with your needs before you employ any of these strategies.


*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on to avoid any Federal Government tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.

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