You Need a Smart Tax Strategy to Get the Most Out of Your Stock Options

When the dot-com boom turned to bust two decades ago, stock options were one of the biggest pain points.

As the market reached its peak, employees took risks with their option grants that bit them hard when prices collapsed. Many people ignored warning signs and believed the stock price could go only one way: up.

Option-based executive pay fell relatively out of favor. But there are signs it made a comeback as the stock market rose to record highs.

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In the past five years, I’ve had more calls from executives seeking advice about stock options than in the previous 10. The trend may have been reinforced by the 2017 tax law changes that made C Corps, which can issue stock options, more attractive due to a 21% tax rate. Couple the rate decrease with the benefits of Internal Revenue Code Section 1202, and option grants are on the rebound.

Executives sometimes stumble into poor choices with their stock options because they lack good advice, often just acting on information from a colleague or carrying on with false optimism about their company’s stock price.

That strategy did not end well in 2000-2001 when the dot-com bubble burst. COVID-19 produces a new wrinkle as certain economic sectors have been crippled. But the stock market has been clawing back pre-COVID-19 gains, so it remains to be seen what the impact might be on stock option pricing.

In other downturns, as the general value of stocks decreased, it created favorable pricing opportunities for those receiving new option grants. Companies have avenues they can pursue if granted options have suddenly lost value, such as repricing and extending expiration dates. The key is not to panic and to evaluate the best course of action.

Understand what you have

Stock options are a form of incentive compensation to reward or retain valued employees. Usually 20% to 25% of the stock grant vests every year as a mechanism to keep employees at the company for a period of time.

To make the most of their option grants, executives need to develop a comprehensive strategy taking into account a wide range of factors, including the tax consequences, their company’s outlook, their risk appetite, their personal balance sheet, and the stage they’re at in their life and career.

Stock options generally fall into two categories: non-qualified stock options (NSOs), and incentive stock options (ISOs). Each has very different implications for planning and tax consequences.

Generally, the grant and the vesting of a compensatory stock option have no tax or financial implications. Quite simply, an option prior to vesting is not property. However, the “exercise” — the point of time when the option holder purchases the stock — can trigger tax implications for both NSOs and ISOs.

For NSOs, the exercise will likely result in W-2 income, requiring withholding of income and payroll taxes, etc. The exercise of ISOs generally will not result in a W-2 situation, but it will depend on the option holder’s strategy. If maximizing the potential benefits of the ISO, the exercise should create alternative minimum tax (AMT) consequences.

Additionally, the ultimate sale of the stock will have tax implications. Understanding these implications to an option holder’s financial situation is critical to have the most efficient outcome.

Considerations on non-qualified stock options

NSOs are more common, because they’re the most straightforward and come with fewer IRS regulatory hoops to jump through. But because they’re almost always treated as ordinary income for tax purposes, they can be less advantageous than ISOs, which can benefit from more favorable capital gains tax rates.

That’s not a small difference, given that the highest federal ordinary income tax rate is 37% and the top long-term capital gains rate is 20%, creating a 17 percentage point spread between the two rates.

Anyone granted NSOs has three main courses of action:

• Exercise and sell
• Exercise and hold
• Defer exercise

Most people opt to defer, playing a wait-and-see game that assumes the shares will rise and to avoid paying tax until the proceeds are in the bank.

Exercise and hold can be a risky strategy, because it requires tax to be paid upfront to benefit from lower capital gains rates in the future. The holder can lose money if the share price plunges and be upside down, because they had to pay more in taxes than the value retained in stock. Still, it may make sense if the company’s prospects are good, the exercise price is relatively low, and the immediate tax consequence at exercise is minimal, meaning fewer out-of-pocket costs at the time of exercise.

As far as exercise and sell, several broader factors should be considered to make a good decision. If you’re 65 and this is your last chance for a big windfall, then taking the chips off the table through exercise and sell could be the best course of action.

Finally, another consideration is how big a chunk of your personal balance sheet do the options represent? If it’s 5%, you can afford to take more risk than if it’s 80%.

Considerations on incentive stock options

ISOs offer more opportunities for smart planning, but also for mismanagement. They are generally treated similarly to NSOs if you don’t do any planning with them, waiting until you are forced to sell the option. That liquidity event could involve the sale of the company, for example. In a sale situation exercising and selling the option simultaneously would count as ordinary income, similar to receiving a bonus and be subject to income and payroll taxes.

But with smart planning over a multi-year period, ISOs can provide substantial tax advantages.

In order to qualify for the preferred capital gains treatment on ISOs you must meet certain requirements, including holding the options for at least two years after the grant and at least one year from the exercise date.

A big consideration with ISOs is they are subject to the alternative minimum tax, which can have a big impact on cash flow and raise the level of risk if the stock price reverses. Although the AMT can be claimed back through a credit in later years, it’s effectively an interest-free loan to the government that can create a liquidity crunch.

There are ways to deal with the AMT risks. Since the AMT can be reduced if you have more ordinary income, it could make sense to exercise and hold ISOs in years when you exercise and sell NSOs.

Another strategy could be to exercise and hold ISOs in years you are going to sell previously exercised ISOs that have met the statutory requirements because those shares sold will create a favorable AMT preference.

As should be clear, being passive about stock options, or “winging it,” can easily turn a good situation into a bad one. Careful tax planning over a period of years is needed to effectively manage these risks and maximize the benefits.