Aug 28, 2023
Exercising Your Private Company ISOs
When you think about exercising stock options, it’s often more of an art than a science. Things can become particularly tricky when you work for a pre-IPO private company.
Incentive stock options (ISOs) have unique tax characteristics and are an increasingly common way to compensate key talent in the private sector. The following is a brief overview of how ISOs work:
- ISOs are the right, but not the obligation, to buy stock for up to 10 years at the stock’s fair market value on the date of grant (typically five years for significant shareholders).
- If the stock is held at least two years from the grant date and one year from the date of exercise, then generally no tax is due at exercise, while any disposition is treated as capital gains for income tax purposes.
For example, let’s say you are granted 10,000 ISO options at $10 per share, and these options expire in 10 years. If you exercise and satisfy the holding period, no tax is due until you sell. Any gains will qualify for the lower capital gains rates.
Compare this to non-qualified options, which are subject to higher ordinary tax when exercised, regardless of whether you hold the stock after the options are exercised.
With private company ISOs, it’s hard to know when to exercise. A common strategy is to wait six months before the company either goes public or is acquired, in order to provide maximum flexibility to sell post-event after blackout periods expire and the capital gains clock starts running.
There are several things to consider before you exercise. Here are five of the most important ones:
1) Watch out for AMT.
ISOs are subject to alternative minimum tax (AMT) at exercise, to the extent that the fair market value exceeds the exercise price.
- What can you do? Have your Wealth Advisor financial advisor and CPA run the numbers to see if AMT may be triggered before you exercise. The last thing you want is a nasty, unexpected tax bill in April when it’s too late to do anything about it.
2) Do you have the cash?
To meet the holding requirements, you need to have the cash available to buy the shares. In the example above, if you want to exercise and hold all 10,000 ISOs, you need to come up with $100,000 of your own money. Do you have enough liquidity to do this? Are you willing to risk it, or more importantly, can you afford to? Run the numbers to see what course of action makes the most sense.
3) Watch your expiration dates!
To realize the value of in-the-money options, you must act by exercising them. If you are considering leaving the company, that ISO status timeframe is reduced to 90 days post-termination. The worst thing you can do is let options lapse worthless or inadvertently lose ISO treatment, so plan accordingly and have resources lined up to execute when needed.
4) Don’t assume the stock price can only go up.
Because of the potential tax savings with ISOs, often that becomes the entire focus of the exercise strategy. What is more important and tends to get lost in the shuffle is the stock’s future performance. If the stock tanks post-exercise and you’re trying to meet the holding period, you risk losing your money. What if the company never goes public, gets acquired or goes bankrupt? It’s important to create a plan to map out scenarios and determine just how dependent you are on these options for your future financial success.
5) Can you lock in long-term goals now?
Remember, with unexercised options, the company doesn’t have to go bankrupt for your options to become worthless. The stock price only needs to drop below the grant price. If your options have value and exercising and selling the stock now means locking in your future, then maybe it’s worth it—even if you must forgo the tax benefits.
ABOUT THE AUTHOR
Gary Pattengale, CPA, CFP
Gary is a Wealth Advisor in our Itasca, IL, office. He specializes in executive and stock-based compensation plans, including stock options, restricted stock and deferred compensation. He combines his tax knowledge, executive compensation experience and capital markets expertise to help clients reduce their tax burdens and achieve each of their unique goals.
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