If you’ve ever left a position with un-exercised Incentive Stock Options (ISO) grants, you’ve faced a difficult decision. Should you exercise ISOs or let them convert to Nonqualified Stock Options (NQSOs)? To make matters worse, your company will make the decision for you if you wait too long. You have 90 days (or 60, or even 30! – depending on your company) to make the decision.
The good news is you are walking away with equity (which wouldn’t generally be the case if you held Restricted Stock Units (RSUs). The bad news is this decision could have a substantial impact at tax time if you make the wrong move.
And the decision (like most good things in tax) isn’t black and white. The answer is most often, both…
Leaving Your Job
Whether you’re leaving your job voluntarily or not, you’ll have at most 90 days to decide what to do with ISOs. This is because the Internal Revenue Code provides no more than three months before your ISOs change character to NQSOs. This is detailed under IRC 422(a)(2).
However, some companies will allow an even shorter time period to make this decision. Often it’s 60 days, but perhaps could be as short as 30 days.
Exercising the options as ISOs allows shares to qualify for long term capital gains rates sooner which could be up to a 20% tax savings on the gain of the shares. The downside is that exercising ISOs can lead to AMT taxes, even if you can’t sell your shares.
If you’ll be leaving your position voluntarily, it can make sense to time your departure to straddle two tax years. This would allow you the opportunity to split the potential AMT tax impact between two tax years.
Let’s look at an example:
Suppose you earn $250,000 per year and you’re trying to decide whether to leave in August or November 2023. You currently have 1,000 ISOs with an exercise price of $5.00. The current company valuation per share is $65.00. If you leave in August, you’ll need to decide whether to exercise all ISOs before the end of the year. If you do exercise them, you’ll incur a $60,000 AMT income adjustment which will result in $7,558 in additional tax due on your 2023 return (filed in early 2024).
Let’s suppose instead that you leave in November. You would be able to split up the exercise between two taxable years, exercising 500 shares in 2023 and 500 shares in 2024. This amount would be covered by the AMT exemption and you would owe no additional AMT tax in either year.
Also, take note of the “Nonrefundable Credit” in our first scenario. The good news is that with this set of facts, you would receive a tax credit for the extra AMT tax paid in 2023 which lowers your tax in 2024. The bad news is that you have to wait a year to get this tax credit.
In addition, depending on the number of shares you exercise, your AMT credit may not be available.
Let’s look at an example where you exercise 3,000 shares using the same prices as above:
Under these new facts, you have an additional $40,000 tax bill in 2023 and only get back $8,000 of the AMT credit the next year. The remaining $32,000 tax credit continues to carry over, but it will be several years until you can take advantage of it.
Up until this point, we’ve illustrated exercising 100% of your shares as ISOs. Depending on the company valuation, this can be an expensive choice. However, this isn’t an all or nothing decision. You could choose to let some of your grant convert to NQSOs.
Allowing your grant to convert to NQSOs (and not exercising) allows you to hedge your bet longer. You can choose to hold on to the NQSOs for the entire ten year window without putting up cash or paying taxes. This also gives you more time to decide when to exercise the options and time them for the best year for tax purposes to help minimize your tax bill.
Leaving your company can be a stressful event, even if leaving voluntarily. It’s a good idea to learn how your options work before leaving. A great place to do some “light” reading is myStockOptions.com. If you’re unsure of how your stock options work, we offer two hours of tax planning assistance for all types of equity compensation. Please feel free to reach out for an introductory call to learn more.