Exercising an Incentive Stock Option (ISO)? Should You Hold the Stock?

This is a guest post from Michael Gray CPA. He counsels individuals on their employee stock option tax questions. For more employee stock option tax resources, see Michael Gray, CPA's Option Alert at StockOptionAdvisors.com.  

When you have decided to exercise an incentive stock option (ISO) and consider the federal alternative minimum tax (AMT) and the net investment income tax, the benefits of holding stock after exercising an incentive stock option are reduced. The "brass ring" of having the gain from the sale of the stock eligible for long-term capital gains rates (15% or 20%) seems attractive, but the 28% alternative minimum tax rate applies
for the excess of the fair market value of the stock at exercise over the option price ("spread") when the option is exercised.  (California also has a 7% alternative minimum tax. Find out the rules for your state.)  The minimum tax credit for this tax "prepayment" is hard for many taxpayers to recover, because they are already subject to the AMT, due to deductions disallowed for the AMT computation, including state income taxes, real estate taxes and miscellaneous itemized deductions.  That means the "spread" at exercise is probably
going to be taxed at a 28% federal tax rate when the dust settles.

In addition, long-term capital gains are subject to the 3.8% net investment income tax when the taxpayer has high adjusted gross income.  That means the total federal tax rate for the initial spread would be 31.8%, versus a maximum federal tax rate of 39.6%.  Is an 8% tax benefit worth the risk of exposure to market volatility of the stock?  It could fall much more than that.

The main time it makes sense to hold the stock is when the "spread" is low and the option price is low.  Then you can probably afford to pay for the stock and AMT (if any) and to take the risk that the value of the stock could fall.  When you do this, you forgo the "time value premium" for the option.  If you have the alternative of just buying the stock for about the same price without exercising the option, you will probably be in a better position by doing that, because you will still have the options to exercise if the value of the stock increases with no downside risk for the options.

An alternative is to exercise the option and immediately sell the stock, provided the stock is publicly traded or there is a "liquidity event" such as a sale of the employer company.  In that case, the gain will be taxed as additional wages, subject to federal tax rates up to 39.6%, but exempt from employment
taxes such as social security and medicare taxes.

These are general comments.  You really should meet with a tax professional familiar with incentive stock options (that's our business!) to discuss your individual situation and have tax planning computations done.  To make an appointment with Michael Gray, call Dawn Siemer at (408)918-3162 on Mondays,
Wednesdays, Thursdays or Fridays.

This article was published in the September 24, 2014 Option Advisor Alert. Republished with permission.