This Insights article was contributed by Chris Massey, CPA (NC License Number 39147), a tax manager at Adam Shay CPA, PLLC.
With the recent nCino initial public offering and stock market surging back to pre-pandemic highs, we are receiving a lot of questions about tax planning for incentive stock options (ISOs). From a tax perspective, ISOs are arguably the most complex type of stock option. The purpose of this article is to cover some of the high-level tax considerations for ISOs and highlight the need for income tax projections and income tax planning when it comes to ISOs.
ISOs are defined in the Tax Code as an option granted to an employee of a corporation (private or public) to purchase stock of the corporation if certain conditions are met (1). Those who earn ISOs may seek to diversify their portfolio if a majority of their net worth is tied up in their company’s stock − say, for example, when their company has a successful IPO and the value of the stock is showing hockey stick type growth. They may also desire to simply liquidate and cash out on the growth. In either case, they are left wondering how to plan for taxes.
Generally, ISOs are not subject to ordinary income tax upon exercise. Ultimately, if the shares are held 1 year after exercise and 2 years after the grant date the employee can qualify for long-term capital gains treatment on the sale of the stock – otherwise known as a qualifying disposition.
Easy enough, right?
Wrong − c’mon, we’re talking about taxes here! As it turns out, there are two tax systems every individual taxpayer must keep track of: the “regular” income tax system (the one most of us think of) and the alternative minimum tax system (AMT). Generally, if your AMT tax is higher than your regular tax, you must pay AMT equal to the amount over regular taxes (you end up paying the higher of the two).
AMT is much different than the “regular” income tax system with its own income recognition rules and disallowance of certain “regular” tax deductions. It also has its own flat tax rates of either 26% or 28%, depending on the level of income.
For ISOs specifically, “regular” tax and AMT are essentially inverses of each other. Upon exercise, income is not recognized for “regular” tax purposes but is recognized for AMT purposes, and vice versa in the year of a qualifying disposition. Note this does not mean you will automatically owe AMT tax, it just means that your alternative minimum taxable income (AMTI) will increase and you have a higher risk of paying AMT. The amount included in AMTI is the difference in value between the exercise price and the grant price.
Thankfully, Tax Reform has helped mitigate AMT tax issues for many taxpayers after its passing which took effect beginning with tax year 2018. Some of these AMT changes benefitting taxpayers were inadvertent such as the cap on state and local tax itemized deductions which are disallowed for AMT purposes and some advertent such as changes to AMT exemptions and thresholds. However, those earning over $200K in income still need to be engaging in some form of tax planning to ascertain if they will be subject to AMT upon exercise of ISOs. Those earning over $1M are the most at risk (2). Other factors, such as filing as married-filing-separately may further increase the risk of paying AMT.
To plan how much in ISO value to exercise before experiencing AMT requires detailed federal and state tax planning iterations. The goal is to exercise as many options as you can without triggering AMT. If there is a need to exercise more than that, see below for additional tax planning opportunities.
If you have already exercised a significant amount of ISOs but have not sold them, there are still several tax planning options to consider in the year of exercise, assuming you would otherwise be subject to AMT.
We discussed qualifying dispositions already but what about disqualifying dispositions? Disqualifying dispositions generally occur when you don’t meet the 1 year holding requirement following the date of exercise. However, if you would otherwise be paying AMT tax it may actually be preferable to a qualifying disposition.
When a disqualifying disposition occurs (ideally within the year of exercise) the ISOs become Nonqualified Stock Options (NQSOs), you pay “regular” income tax on the sale and have a favorable adjustment for AMT purposes (reduced AMTI). However, it’s not an all or nothing decision. You can execute disqualifying dispositions for some of the ISO tranches and not others.
The question then becomes: how many shares do you need to sell through disqualified dispositions in order to achieve the optimal amount of tax mitigation by reducing the AMT to zero? Again, this is a complex question that requires doing tax projections − an estimate of your total taxable income and tax liability for a given period − to understand the overall impact on your taxes under different scenarios.
Tax Reform also introduced an opportunity to defer tax recognition for up to 5 years by making an §83(i) election. However, this is only available for private companies and is somewhat narrow in its application.
ISO holders following the status quo by holding and selling shares without a tax plan in place may end up getting surprised when they file their tax returns the following year. It’s recommended that you involve all members of your personal advisory team including your CPA, Financial Planner, and Estate Planner.
Contact us at Adam Shay CPA, PLLC to figure out the best tax plan for you.
Source (1) §422(b)
Caroline Montgomery, CPA (NC License Number 39017), MSA, is tax manager and partner of Adam Shay CPA, PLLC. The most rewarding part of what she does is helping business owners and individuals achieve their goals, all while working with a dynamic team that is growing quickly. The firm focuses on a proactive approach by encouraging clients to minimize taxes via income tax planning and projections, or by focusing on other areas of their business as part of the firm's Virtual CFO services. The firm also offers tax preparation, fraud and forensic accounting and tax issue resolution services. She moved to Wilmington in 2014 and started at the firm in 2015. Caroline graduated with her her undergraduate and graduate degree in 2010 from East Carolina University. She is actively involved with NourishNC as their Treasurer and enjoys volunteering with various organizations throughout New Hanover County. In her free time, Caroline enjoys spending time with her husband, Mike, and dog, Mason, as well as travelling and going to the beach.
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