Tax planning with incentive stock options (ISOs) presents a variety of tradeoffs and potential outcomes depending on when you exercise and how the valuation of the shares changes over time.
A common strategy is to exercise ISOs and hold shares one year from exercise (and two years from grant) in order to qualify for the favorable long-term capital gain treatment (LTCG).
LTCG treatment typically provides substantial tax savings relative to your normal income tax rate. For example, if you’re in the highest income tax bracket (37% in 2022), you’d have an LTCG rate of 20%, saving you 17% in income taxes from the exercise and hold strategy.
Be Mindful Of AMT Potential
However, there are downside risks to an exercise and hold strategy with ISOs. Mainly, the potential for alternative minimum tax (AMT). AMT is a separate tax calculation that is compared to your regular taxable income. Since the difference between your strike/exercise price and the valuation is considered “phantom income” (preference item) for AMT calculation purposes, this can cause a large unanticipated tax bill come filing time.
Whenever considering an exercise and hold strategy with ISOs, it’s best to work with a tax professional to understand the AMT potential. The greater the delta between your strike/exercise price and the current valuation, the more potential there is for an AMT liability.
When Your Exercise Price And 409A Valuation Are Close
In the case of being a startup employee, when your strike/exercise price and the 409A valuation are close together, this is the most advantageous time to consider exercising. Why? Because you’re avoiding an AMT potential since there is no (or very little) spread between the valuation and exercise price.
Again, there are downside risks. Most obviously, the potential that the startup vision never materializes via acquisition or IPO, and the shares become worthless. In which case, you’d lose the money you used to exercise your options. Since you were an early employee, your strike/exercise price should be low (less than a dollar, for example), meaning the potential losses shouldn’t be devastating.
When Should You Early Exercise ISOs?
What if you have the option to early exercise your ISOs and why would you do so? You’d consider an early exercise if you have a strong conviction in the company’s growth potential and want to lock in the spread between your strike/exercise price and the current 409A valuation to minimize future AMT potential.
Side note – if you early exercise for AMT mitigation purposes, it’s crucial you file an 83(b) election within thirty days of the ISOs being granted. An 83(b) election is a record to the IRS that you want to be taxed on shares you have yet to receive (to lock in the spread). Assuming the growth potential of your shares remain intact, this early exercise strategy can provide tremendous tax savings (from LTCG treatment) and AMT avoidance (as the 409A valuation increases).
Lending Options For Early Exercising ISOs
With early exercise ISOs becoming more common, a variety of lending solutions have entered the marketplace for employees looking to access their illiquid equity. Should you borrow money to early exercise your options? Again if you are an early employee, your strike/exercise price should be low enough that you can come up with the cash without seeking borrowing money. As long as you understand the risks of early exercising, it could make sense to get the clock ticking on LTCG treatment.
If you can’t afford to exercise your options, consider all of your resources available to you, such as cash flow flexibility, taxable investments, home equity, personal loans, etc. Many lending solutions specifically designed for accessing illiquid equity comp include a “pledged stock fee,” which allows the lender to be compensated in equity and benefit from the potential liquidity event.
Given the windfall potential, I would strongly consider alternative options before pledging a percentage of stock. As with any financial decision, consider the range of possible outcomes. If you feel you’re close to a liquidity event, it’s usually best to hold on even if you can’t afford to exercise your options.
So should you early exercise your ISOs? To summarize, if you have the cash flow flexibility with a low strike/exercise price and are confident in the company’s growth trajectory, locking in the spread relative to the current 409A valuation can provide tremendous long-term tax savings.
Should you borrow money to early exercise your ISOs? This is a risky strategy for many reasons, and it’s usually best to focus on working with the resources you have before seeking outside funding.
As always, it’s recommended that you consult your financial advisor and tax professional before executing any of the strategies discussed. This blog post should not be relied upon for personalized tax or financial advice.