First of all, if you are reading this for personal financial reasons, then congratulations. As a recipient of employer stock options, you have the opportunity to own shares of your company. Stock options can be a powerful wealth-builder. If granted, chances are you have a windfall headed your way. Be sure to have a plan in place regarding the exercise of those options and subsequent sale of stock.
There are several considerations that should factor prominently in your decision-making process. These actions may have major tax implications and, if done improperly, could effectively reduce the amount of that windfall.
When formulating a plan to exercise your stock options, there are some important questions to ask: What exactly is your stock option? When can you move on that stock? What are the tax implications? What valuation does your company have?
From just $107.88 $24.99 for Kiplinger Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
Stock Options
Understanding what type of stock options you own is significant when considering your financial position and determining your next move. Stock options come in a few varieties. Incentive stock options (ISOs) are a company benefit that give an employee the right to buy shares at a discounted price, while delaying taxes due until those shares are sold. With non-qualified stock options (NSOs) taxes are due both when you exercise the option (purchase shares) and sell those shares.
Another common employee compensation package is restricted stock units (RSUs). RSUs give an employee interest in company stock but have no tangible value until vesting is complete. It is important to know which type of options you have, and the implications of each.
Timing the Sale of Your Stock
Be sure to understand the earliest date at which your stock can be sold as a long-term capital gain. This tax-advantaged rate applies to stock held more than one year. Additionally, two years must have passed since the option to buy those shares was granted. Remember, you may have a post-IPO lockup period during which you will not be able to sell stock. A lockup period is a window of time when company insiders are not allowed to redeem or sell shares of their company. Lockup periods can vary but typically span six months post-offering.
A common strategy is exercising options six months before the IPO, which starts your stock holding period. Assuming a six-month lockup, any stock you sell thereafter will be taxed as a long-term gain, as you have now held the stock for one year. This strategy gives you flexibility to exit your position at the lower capital gains rate and earliest calendar date possible if you have concerns about your company’s prospects or need liquidity. On the contrary, if you think the stock could soar, you can hold it. Regardless, the early exercise of options gives you, well, options.
Plan Ahead for Alternative Minimum Tax Issues
If you exercise ISOs be aware of the rules surrounding the Alternative Minimum Tax (AMT.) The AMT applies to taxpayers with high income by setting a limit on deductions and exclusions. It helps to ensure that certain taxpayers pay at least a minimum amount of tax.
If you are subject to the AMT, exercising ISOs may count against you in the year in which they are exercised, so take into account the probability that your company will be successfully brought to market. Early exercise could negatively affect your balance sheet if the IPO is delayed or canceled and you were planning to pay that AMT with proceeds from the sale of stock to the public. For example, COVID-19 surely threw a wrench in the gears of recent IPOs such as Airbnb and likely in the plans of many executives standing to profit from it.
On the other hand, if you pay AMT on exercised ISOs when company stock is low, you may not get hit with it again after selling the stock at a later date. If it soars after the IPO, then exercising and paying AMT early would have been a smart move.
Valuation: Get an Idea of What Shares Are Worth
In the public stock market, there is a published bid-ask spread for each security throughout the trading day, thus providing a means of valuation for a stock or option. In the private marketplace, the valuation of a company is less clear because it is calculated infrequently. While there are some “exchanges” for private shares, transactions occur infrequently, and the bid-ask spread is often wide. You could certainly estimate based upon the most recent funding round or Venture Capital firm valuation.
Additionally, many private company values are based on the most recent 409(a) valuation. A 409(a) is an independent appraisal of the fair market value (FMV) of a private company’s common stock. Long story short: You can’t make a decision to exercise an option without understanding what a share of stock is worth.
Hire a Pro
DIY projects frequently end up costing a homeowner more money than just hiring a pro in the first place. As you review your stock options, it's important to consider all variables. Having a team of trusted advisers by your side who can properly evaluate your stock options, portfolio and goals can bring you confidence that you are making informed decisions.
A certified public accountant (CPA), a financial planner and estate attorney should be vital members of your decision-making team when navigating your ownership interests from private to public. A CPA can typically model your estimated tax liabilities given your unique circumstances. If your windfall is substantial enough, a financial planner and estate attorney will strive to ensure your wealth is preserved for yourself and future generations through proper planning. Be sure to hire the right person for the job — preferably someone who has dealt with the complex circumstances surrounding private stock, stock options and IPOs.
Every company is different, as is every IPO. It is important to read the fine print regarding your rights and requirements as the holder of options or stock in a private company before deciding what to do in the months before and after an IPO. If uncertain, be sure to consult professionals with experience in this area.
Content in this material is for general information only and not intended to provide specific advice, tax advice or recommendations for any individual. We suggest that you discuss your specific tax issues with a qualified tax adviser. Securities and advisory services offered through LPL Financial, a Registered Investment Adviser, Member FINRA/SIPC.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Securities and advisory services offered through LPL Financial, a registered investment adviser. Member FINRA/SIPC.
-
A Lesson From the School of Rock About the MarketsIt's hard to hold your nerve during a downturn, but next time the markets take a tumble, remember this quick rock 'n' roll tutorial and aim to stay invested.
-
I retired at 65 with $7.8 million and feel like I over-saved. My 40-something son is on the same path. Should I tell him to reconsider?We ask financial experts for advice.
-
A Lesson From the School of Rock (and a Financial Adviser) as the Markets Go Around and Around
It's hard to hold your nerve during a downturn, but next time the markets take a tumble, remember this quick rock 'n' roll tutorial and aim to stay invested.
-
I'm a Financial Pro: This Is How You Can Guide Your Heirs Through the Great Wealth TransferFocus on creating a clear estate plan, communicating your wishes early to avoid family conflict, leaving an ethical will with your values and wisdom and preparing them practically and emotionally.
-
To Reap the Full Benefits of Tax-Loss Harvesting, Consider This Investment Strategist's StepsTax-loss harvesting can offer more advantages for investors than tax relief. Over the long term, it can potentially help you maintain a robust portfolio and build wealth.
-
Social Security Wisdom From a Financial Adviser Receiving Benefits HimselfYou don't know what you don't know, and with Social Security, that can be a costly problem for retirees — one that can last a lifetime.
-
Take It From a Tax Expert: The True Measure of Your Retirement Readiness Isn't the Size of Your Nest EggA sizable nest egg is a good start, but your plan should include two to five years of basic expenses in conservative, liquid accounts as a buffer against market volatility, inflation and taxes.
-
New Opportunity Zone Rules Triple Tax Benefits for Rural Investments: Here's Your 2027 StrategyNew IRS guidance just reshaped the opportunity zone landscape for 2027. Here's what high-net-worth investors need to know about the enhanced rural benefits.
-
The OBBB Ushers in a New Era of Energy Investing: What You Need to Know About Tax Breaks and MoreThe new tax law has changed the energy investing landscape with expanded incentives and permanent tax benefits for oil and gas production.
-
Ten Ways Family Offices Can Build Resilience in a Volatile WorldFamily offices are shifting their global investment priorities and goals in the face of uncertainty, volatile markets and the influence of younger generations.
