With the summer’s boom in tech company initial public offerings (IPOs) and direct listings continuing into the fall, it’s a good time to review planning issues for your equity compensation, such as incentive stock options (ISOs), non-qualified stock options (NSOs), restricted stock units (RSUs), and restricted stock during liquidity events.
Stock options, RSUs, and restricted stock each have their own tax consequences and investment considerations. Taken separately, these considerations are confusing enough. But when you have all of these, or two or three of them, together, it can get pretty tangled.
Let’s start to sort it out. Important questions are whether to sell, how much to sell, how much of each type of stock to sell, and in what order to sell.
An Example
For example, let’s say you hold ISOs with a low strike price, NSOs granted later with a higher strike price, and double-trigger RSUs that are partially vested. Let’s say also that you exercised some of your ISOs several years ago and are now holding those shares.
Once the IPO or direct listing occurs, the vested RSU shares will be delivered to you, and you will owe ordinary income tax on the value of those shares. (More technically, the RSUs for which you have met the service requirement will then be vested because the second triggering requirement, a liquidity event, has been met).
Nothing happens immediately with your stock options (ISOs or NSOs) or held shares. And there are no tax consequences until you take further action, such as exercising your options, selling your option shares, or selling your held shares.
In this example, one strategy to meet your diversification goals would be to sell vested RSU shares first, then exercise but not sell some or all of the ISOs, and then sell NSOs.
Equity Compensation Tax Consequences
Let’s break down the tax consequences of this plan. First, there is no tax benefit to holding RSU shares once they vest and have been delivered to you. You will owe ordinary income tax on the value of the shares once they are deposited into your account. Any further gain will be taxed as short-term or long-term capital gain, depending on whether you hold the shares for one year or more.
If you sell the shares right away, there won’t be any gain, and you won’t owe any additional tax. If you hold the shares for one year or more, any gain after you received the shares will be taxed at the lower federal long-term capital gains rate.
Exercising ISOs will start the clock on the time requirement to get favorable tax treatment. If you sell the shares at least two years after the grant date and one year after you exercise (both must be true), any gain will be taxed as ordinary income for regular tax purposes. For low strike price ISOs, the tax savings can be considerable.
ISOs and Alternative Minimum Tax
There are a couple of tax-related gotchas to be aware of with ISOs. While there is no tax consequence to exercising ISOs for regular tax purposes, there is an Alternative Minimum Tax (AMT) consequence. Under the parallel alternative tax system, any gain on your ISOs is taxable when you exercise your options.
If the income from exercising ISOs causes your total taxable income under the alternative tax system to be greater than your income under the regular tax system, you will “owe AMT.” This means you will report that additional income on your tax return. This is what happens when you “have to pay AMT” on ISO exercises. You’re paying the difference between the tax calculated under the two tax systems—and of course, you have to pay the higher amount.
An even bigger gotcha is that AMT tax from the exercise of ISOs is owed even if the stock price later drops. This assumes you don’t sell the shares within the year of exercise, which might be the case if you exercise and intend to hold for one year to get favorable long-term capital gains treatment under the regular tax rules. This can cause serious problems if you can’t raise enough cash to pay your tax bill because the stock price has dropped.
For this reason, it can be a good idea to exercise your ISOs early in the year so that you maximize the amount of time toward the one-year holding rule (assuming that you will also meet the two-year-from-grant rule) before the end of the year. If the stock price drops, there won’t be any benefit to holding for long-term capital gain treatment as there won’t be any gains. So you can sell those shares within the year and eliminate the AMT tax bill.
Your decision about the number of ISO shares to exercise doesn’t have to be all or nothing. You can choose to exercise none, some, or all of your ISOs depending on your tax situation, funds available to cover tax payments, and how many shares you want to exercise and hold for favorable long-term capital gains tax treatment.
For example, if you don’t have a strong preference for exercising and holding shares to get long-term capital gains tax treatment later and you are trying to minimize current-year tax, you may decide to exercise only a portion of your ISO shares.
One amount you could consider exercising is the amount that gets you up to the point you “have to pay AMT.” Below a certain amount of shares exercised, you may not owe any AMT at all. Or, in another example, you may decide it’s OK to pay some AMT in order to exercise and hold more shares now for better tax treatment later. In this case, you might exercise a greater number of ISO shares, which takes you above the point at which you “have to pay AMT.”
As the final piece of this example, you’ll next exercise and immediately sell your NSOs. The gain on NSO exercise and sales is taxed at the higher ordinary income rates. There is no special, favorable tax treatment for NSOs as there is for ISOs. With NSOs, you might as well sell at the same time you exercise; there is no advantage to exercising NSOs and holding the exercised shares.
Consider Your Specific Situation
There are countless variations of this plan and other strategies that might make sense depending on your individual facts and circumstances. The type of options and RSUs you hold, the strike prices on your options, your diversification goals, your overall tax situation in the current year and over the next few years, and your decision on how much to sell (the subject of Part II)—these all are important considerations.
If you’d like to learn more, a good resource is my book, Personal Finance for Tech Professionals.
