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The alternative minimum tax (AMT) acts as a sort of parallel tax system to the regular federal income tax system. For taxpayers, this means they need to calculate their income twice: once under the regular tax rules and a second time under AMT. After running this calculation, taxpayers then pay whichever is highest.

AMT was implemented in 1969 to ensure individuals earning high income pay their fair share in taxes. The problem, however, was that AMT was not originally  adjusted for inflation. The end result caused many middle-class taxpayers to be unnecessarily subject to paying AMT.

The new rules that updated requirements around paying AMT were introduced recently, and went into effect for the 2018 tax year. Both exemptions and phaseout limits were increased, meaning it’s less likely you’ll need to pay AMT.

Unfortunately, if you have incentive stock options and plan to exercise and hold them, even the recent changes may not be enough to help you avoid AMT completely.

Because of that, you should take the time to familiarize yourself with this tax as it’s possible you may need to pay it in the future.

How Is AMT Calculated?

To calculate AMT, you first need to calculate your Alternative Minimum Taxable Income (AMTI).  AMTI is a different calculation than the calculation for your regular taxable income. It adds back certain deductions and adjustments into your taxable income, and many of deductions you enjoy on regular federal taxes do not apply.

AMTI also includes the bargain element (the difference between the exercise price of your stock option and fair market value at exercise, multiplied by the number of shares purchased) of exercising your incentive stock options as income.

For comparison, the bargain element is not counted when figuring your regular income if you exercise and hold the shares. The result of its inclusion in income means exercising ISOs may inflate your AMT in the year you exercise your incentive stock options.

Once your AMTI is calculated, then the exemption is applied to find your Alternative Minimum Tax Base:

Alternative Minimum Tax Base = Alternative Minimum Tax Income – Exemption

If your AMTI is below the 26%/28% Dividing Line, you’ll be taxed at a flat 26% rate. If AMTI is over the dividing line, then the portion of your income below the dividing line is taxed at 26% and the remainder is taxed at 28%.

A Note on the Exemption

If your income is high, part of your exemption may go away. This is known as the phaseout. If you fall into the phaseout, then $1 disappears from your exemption for every $4 above the phaseout.

For individuals with extremely high incomes, your exemption can be reduced to zero.

Tax Filing Status 2018 Exemption 2019 Exemption 2018 Phaseout 2019 Phaseout 26% / 28% Dividing Line
Single $70,300 $71,700 $500,000 $510,300 $97,400
Married File Jointly $109,400 $111,700 $1,000,000 $1,020,600 $194,800
Using an Example to Show the Impact of the Alternative Minimum Tax

Let’s assume you’re a married taxpayer and you have an AMTI of $1,050,600 in 2019. You have exceeded the phaseout limit by ($1,050,600 – $1,020,600) = $30,000.

This means you need to recalculate your exemption, which is $111,700 if you did not exceed the phaseout. Your new exemption is your full exemption amount less a quarter of the amount they exceed (0.25 x $30,000) = $7,500.

That makes your new exemption ($111,700 – $7,500) = $104,200, and your new Alternative Minimum Tax Base ($1,050,600 – $104,200) = $946,400.

Remember there are two tax rates: 26% for the amount under $194,800 and 28% for the amount over. Given this, your tentative minimum tax would be:

26% x $194,800 + 28% x ($946,400 – $194,800) = $261,096

If this amount exceeds your regular tax, the amount in excess is the AMT you have to pay. For example, if your regular tax is $150,000 and your tentative minimum tax is $261,096, you will pay $111,096 in AMT.

AMT Counts Exercising Incentive Stock Options as Income

Exercising your incentive stock options counts as income for AMTI calculations, even if the gains are not realized. The calculation of regular tax, on the other hand, does not consider buying and holding a taxable event.

Specifically, the bargain element, which is the difference between the price of your options and the market price multiplied by the total number of stocks purchased, is included in the calculation.

This is not to be confused with a capital gains tax, which is the tax paid when stock is sold.

Since AMT counts exercising incentive stock options as income, it can lead to an unexpectedly high amount of taxes owed for the year.

Imagine if you exercised 10,000 incentive stock options for Company X, for which you had an exercise price of $5 a share. If the current stock price is $85 a share, then the bargain element per share would be: ($85 – $5) = $80.   If all 10,000 shares were exercised, the total bargain element would be $80 x 10,000, or $800,000.

If this were a non-qualified stock option, the entire $800,000 would be taxed as ordinary income in the year of exercise, regardless of whether or not share shares were subsequently sold or retained.

Incentive stock options — and subsequently, the calculation of the AMT — treat the $800,000 of bargain element as if it were a non-qualified stock option (assuming the shares are held past the calendar year end).

The entire $800,000 is included as income when calculating AMT, even though it is not included as income for regular tax purposes. Only when the shares are sold in a final sale will they be included in the regular tax calculation.

Continuing the example, $800,000 of income is included in the calculation for AMT. Given the AMT tax rate of about 28%, the taxpayer’s AMT may grow by over $220,000.

The AMT Credit

Fortunately, selling your incentive stock shares does not create more AMT taxes. Instead, it may lead to something called AMT credit — and that’s a good thing. It may lower your AMT amount the year in which you sell your incentive stocks.

When you sell your incentive stock option shares, the income that was included for calculating AMT when you exercised the shares is now a negative deduction in the year of sale. This negative deduction may lead to a tentative minimum tax that is lower than your regular tax.

If you have a tentative minimum tax that is lower than your regular tax and you have carryforward AMT credit, you may be able to get that credit back in the year of sale. The result may mean a lower tax bill than you would have had otherwise.

In fact, its possible that liquidating your incentive stock can potentially result in enough AMT credit to cover the full AMT tax you initially paid. But there is a cap on how much AMT credit you can gain in a year.

If you don’t use your full AMT credit in one year, it carries forward to subsequent years for future use.

The AMT Crossover Point

It is possible to avoid paying AMT when exercising incentive stock options, but this requires good tax planning and knowing your AMT crossover point.

The AMT crossover point is the point where your AMT tax becomes higher than your regular tax. Remember how AMT is only paid when it is higher than the ordinary tax rate? This crossover point can be used to your advantage when exercising ISOs.

When you exercise an incentive stock option, the bargain element is counted as income under AMT. For large transactions, this can bump the AMT  higher than regular tax.

However, if your AMT tax rate is lower than your regular tax rate, then you have room to exercise some incentive stock options without paying AMT.

To do so, you can calculate the difference between your regular tax and AMT tax. Once you know the difference between the two, you can use this as an indication to determine how much bargain element you can incur and use that information to determine how many ISOs you can exercise.

The larger the spread between the regular tax and the tentative minimum tax, the more stock you can buy. The smaller the spread, the less stock you can buy.

Let’s assume that you want to exercise some of your ISOs and that you have calculated your regular and AMT taxes to be the following:

  • Regular Tax: $70,000
  • Tentative Minimum Tax: $50,000

In this scenario, you need to pay the higher of the two calculations, which is currently $70,000 in regular tax. It also means you have a spread of $20,000 between the two tax calculations.

It is possible to determine how much incentive stock to buy by dividing the spread by the AMT tax rate of 28%:

$20,000 / 0.28 = $71,428.57

This number indicates the taxpayer can exercise and hold $71,428.57 worth of bargain element without paying additional AMT taxes.

If we further assume that you have incentive stock options with a bargain element of $100 per share, we can determine that you can exercise 7,142 shares (rounded down) to fill up the entire AMT free bucket.

$71,428.27 / 100 = 7,142 options

Key Takeaways

The alternative minimum tax is not new, but recent changes have increased exemption and phaseout limits. These changes make AMT more forgiving towards the middle class, but may also give more opportunity for exercising incentive stock options without incurring extra taxes.

It is possible to minimize AMT payments by planning the number of incentive stock options you purchase around the difference between your AMT and regular tax owed.

However, this step requires precise planning and calculations and may be best done near year-end. This likely minimizes any taxable surprises from occurring.

Ultimately, every tax situation is different, and you should run a detailed tax calculation for AMT (or with an advisor) before making a final decision on what strategy is best to use around your stock options.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

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The choice of when to exercise your incentive stock options can be a difficult one, with serious implications for financial planning and taxes. When your company is still pre-IPO, that opens up an entirely separate set of concerns that you may need to be aware of.

The issues associated with pre-IPO incentive stock options (ISOs) are particularly relevant now, as early-stage companies increasingly find private funding sources and delay the date of their IPO. As the length of time between startup and IPO increases, more and more employees are facing the question of the costs and benefits of pre-IPO ISO exercise.

In this article, we will look at six important things to consider if you have pre-IPO incentive stock options.

1 – How Do Pre-IPO Incentive Stock Options Work?

Most of the stock option explanations you’ll find online and in textbooks assume that the company’s stock is publicly traded. With a public market, you can easily compare the exercise price of your incentive stock options to the current trading price of your company’s stock to get a good estimate of what your options are worth. Even if you don’t plan to exercise or sell right away, you have a good baseline value to use in decision making.

In contrast, pre-IPO shares don’t trade on the open market, and therefore may not have a readily defined price. If you choose to exercise pre-IPO, the estimated value of the stock you purchase is likely based on the most recent assessment of your company’s fair value, which is calculated periodically.

You’ll likely need to wait until the next valuation to know whether or not the stock price is up or down, and whether or your exercise was a good decision.

Once you have exercised your options, you will own shares in your company. While these shares have some similarities with shares of publicly-traded companies, there are also important differences, which are discussed below.

2 – Is There an IPO Date in the Near Future?

What does it really mean to be pre-IPO? Simply that your company is not publicly traded, but may do an offering in the future. However, that is not necessarily a guarantee that the IPO will come soon, or indeed, ever.

When doing your financial planning, you should take into account the possibility that an IPO may come later than expected, if at all. More and more frequently companies may be able to secure necessary financing from venture capital and bank syndicates, which makes an IPO less urgent from management’s perspective.  Or alternatively, the company simply do not grow to the point that warrants an IPO.

Has an IPO date been announced? Or at least a target year or quarter? Even in the case of companies that have already begun the underwriting process, IPO dates can be delayed significantly if market conditions change.

As a result, you should take contingency planning into account when thinking about your pre-IPO exercise plans. What happens if the IPO takes place later than expected? How would this affect your cash flow and tax situation? For example, what if you exercise your pre-IPO incentive stock options, pay for them in cash, pay the tax, and the lPO never occurs. You may find yourself paying cash for something that you may never get back in return. It’s best to be prepared for good and bad outcomes when dealing with uncertain future events.

3 – What If the IPO is Late (Or Never Comes At All)

If you choose to exercise pre-IPO, you will own shares of a non-public company. In some ways this is similar to owning shares of a public company, but there are some important differences.

For example, while you may be able sell your shares to another party, some instances it may not be easy to do so.  Some plans may not allow for the sale of pre-IPO shares at all.

If you are allowed to sell to a third party, you will have to find someone else to buy the shares. While exchanges for buying and selling shares of private companies exist, they can be opaque and illiquid compared to public stock exchanges. You may find that you are only able to sell your shares at a price below what you consider to be fair market value.

After all, one of the most important advantages of an IPO is to provide you with an easy venue for buying and selling shares. Prior to listing, you may find this lack of venue to be an obstacle in realizing the full value of your options.

Even if you can sell, there may be restrictions on the sale of your stock pre-IPO, such as right of first refusal This means that the board or another party has the option to buy your shares from you before you can sell to a third party. Again, you should check with your plan document to see what you can and cannot do.

4 – Are You Prepared for a Lockup Period?

Once an IPO takes place, sale of your shares will likely become much easier, and pricing more transparent. However, you should be prepared for a lockup period that may restricts sale of stock. During this period, often 6 months post IPO, you may not be able to sell your shares of stock per the agreement your company has with an investment bank (the company helping your firm go public).

Of course, you may wish to hold on to your shares during this period for other reasons, hoping for stock appreciation or waiting for the long-term capital gains period to complete. Since long-term capital gains are taxed at a lower level, it may be advantageous to exercise your incentive stock options early so that you can begin the holding period requirements, meaning a post-IPO sale will be considered a long term gain sooner rather than later.

In any case, it’s important to take the lockup period into account for your financial planning, since you won’t be able to tap into the value of those shares until after the lockup period has expired should you have a sudden need for liquidity.

5 – What are the Tax Implications of a Pre-IPO Exercise?

While taxes are always important to take into account when considering the timing of exercising your incentive stock options, it’s an especially crucial consideration for pre-IPO companies. Why? Because these shares can be more difficult to liquidate, meaning you may incur a tax liability upon exercise without being able to sell some of the shares you purchased to pay your tax bill.

The tax effect of your exercise will depend on whether you hold incentive stock options or non-qualified options (NSOs). The pre-IPO sale of ISOs in particular can create tax issues, because exercise of ISOs may trigger an alternative minimum tax (AMT) liability.

The AMT is a dual tax system, where taxes owed are calculated using both the rules for ordinary income and an AMT calculation. You then pay the higher of the two numbers, AMT or ordinary income. So, by exercising your pre-IPO ISOs, you can potentially increase the overall amount of taxes you owe. However, you may also be exercising at a point when the AMT is the lowest it will be if the price continues to appreciate.

For AMT purposes, the bargain element (the difference between the exercise price and fair market value at exercise of your ISOs) may add to your income in the year of exercise.

Any pre-IPO ISOs you exercise may increase your taxes for AMT purposes, but won’t increase your regular tax liability (assuming you don’t sell your ISO shares during the year.) If your AMT taxes exceeds your regular taxes, you’ll have to pay more than you otherwise would.

The end result is that simply exercising and holding your shares can cause your tax liability to increase. If you need to sell some of your shares to cover those taxes, you may not be able to.

The tax effect is somewhat different for NSOs. Exercise of your NSOs won’t trigger an increase in your AMT liability, but the bargain element is still taxable as ordinary income. Therefore, exercise will increase your income in the year of the exercise, which can increase the taxes you will need to pay.

6 – Advantages of a Pre-IPO Exercise of Incentive Stock Options

Despite the tax issues discussed above, there can be considerable advantages to pre-IPO option exercise. Many employees of pre-IPO firms are hopeful that there could be substantial stock appreciation in the years following an IPO. If this turns out to be the case, then exercising in the pre-IPO period can have tax advantages in the long run.

For ISOs, exercising early can help to limit the total AMT effect. While the exercise itself can trigger an AMT liability (depending on the assessed fair market value of the stock), waiting several years to exercise your options could increase the AMT effect substantially if there is significant stock appreciation.

Imagine two alternative scenarios, one in which you exercise your ISOs pre-IPO, and another where you exercise two years later, after the IPO has gone to market, the lockup period has expired, and the price of the stock has appreciated.

Shares Exercise Price FMV
Pre-IPO 10,000 $1 $2
Post-IPO 10,000 $1 $35

If you exercise pre-IPO in this example, your bargain element is ($2 – $1) x 10,000, or $10,000. So your taxable income for AMT purposes will increase by $10,000, limiting the possibility that you’ll be exposed to the AMT in the year of exercise. If we assume you are subject to AMT and assume at flat 28% tax rate, the total AMT bill will be $2,800.

Waiting until the post IPO period to exercise your incentive stock options, however, means that your bargain element increases substantially, to ($35 – $1) x 10,000, or $340,000. This could mean a much larger AMT liability in the future. In fact, at the same assumed 28% tax bracket, the total AMT bill is $95,200.

Of course, nobody can predict what the stock market will do in the coming years. But given the potential for price appreciation between IPO and following the IPO, you should take this possibility into account when doing your planning.

The other tax advantage of pre-IPO exercise to consider is that the clock for a qualifying disposition begins at exercise.  If you exercise pre-IPO, you have begun the holding period of your stock option on the date of exercise.  This means that you may achieve the qualifying disposition holding requirement when the post IPO lockup period expires.  This, in turn, may give you additional flexibility to sell your ISO shares sooner than had you waited to exercise post-IPO, and still obtain potentially preferential long-term capital gains treatment.

What Now with Your Pre-IPO Incentive Stock Options

Any incentive stock option exercise decision should also be considered alongside your other financial planning needs. But as you can see, the unique issues associated with pre-IPO option exercises make careful planning especially urgent.

While there may be several advantages to a pre-IPO exercise such as a lower AMT bill or the start of your qualifying disposition holding period, the potential benefits should be weighted against the risk of buying stock that you may never be able to sell.

This conversation often circles back to good financial planning.  Discussing what you are looking to achieve, what risk you are willing to assume, how much you believe in the company, and where you are in your lifecycle.

Once you evaluate the option in the scope of a larger plan, you can be informed to make a good decision about whether or not a pre-IPO exercise is a good idea for you.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

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Incentive stock options (ISOs) are a form of compensation distributed by a company to their employees. Typically, companies use ISOs as a vehicle to retain top employees, reward specific milestones or successes or as an incentive when hiring new employees.

ISOs can be a lucrative long-term compensation benefit, particularly if you work for a company that is growing quickly and has a rising stock price. Because they may be highly valuable, incentive stock options have several components that are worth studying.

1 – What is an Incentive Stock Option?

An incentive stock option is a specific type of employee stock option that allows you the right to purchase shares of stock at a predetermined price at some point in the future. You are given – or “granted” – a certain number of incentive stock options allowing you to purchase that number of shares of stock.

When you purchase company stock shares via your option, the process is known as exercising your incentive stock options. There are several aspects to exercising your options, as you’ll see below.

2 – How Do You Receive Incentive Stock Options?

You are awarded incentive stock options from your company in the form of an option grant. Usually you’ll be required to “accept” the option grant before it becomes official by signing an acceptance form. This is a formality.

When you receive an incentive stock option grant from your company, it will include several elements that will impact what you can do with your options and when. This information will likely be provided in a combination of documents including the plan document, the plan prospectus, and your specific stock grant details.  It may be wise to obtain this information from your HR department, as company plan rules can differ.

3 – What is Included in an Incentive Stock Option Grant?

Your ISO grant will include the number of share options you are being granted. This is equal to the number of shares you can exercise and buy.

The ISO grant will also include a share price, called the “strike” price or “exercise” price, which is often set by the stock price on the day the company completes the option paperwork. The exercise price determines how much you will pay for each incentive stock option.  This price, multiplied by the number of granted options will tell you how much it will cost you to exercise all your options.

Your ISOs will also include a grant date. This is important because it may affect both when you can exercise your options and the tax implications, which we’ll cover shortly.

The option grant will also include a vesting schedule. The vesting schedule is the timeframe that dictates when you can exercise your stock options.

For example, a 5-year schedule might vest 20% of the ISOs per year until fully vested. Often, vesting schedules are designed to reward you for staying with the company for longer periods of time and can be used as a retention tool for valued employees. Should you leave the company before your ISOs vest, the options may be subject a forfeiture provision where the company will take back unvested options upon your departure.

4 – What is the Process for Exercising Your Incentive Stock Options?

You can exercise ISOs in one of several ways. The approach you choose will depend on your short- and long-term financial goals, cash position, tax situation, need for immediate income, among others. This is an important decision and often worth consulting an investment professional to determine the best approach for your situation.

First, after some or all of your incentive stock options have vested, you can pay cash up front to purchase them. For example, if you were granted 1000 options at an exercise price of $10 per share, once vested, you could purchase the 1000 shares of stock for $10,000 (1000 x $10 = $10,000.) While this is a large sum of cash, purchasing the shares up front can be advantageous if you plan to hold the shares for a long period of time to take advantage of certain tax benefits and hoped-for stock price increases.

You can also exercise your ISOs through a cashless transaction where you immediately sell your vested shares as soon as they are exercised, using the profits to pay for the option costs, and potential taxes, keeping the remainder.

A third approach is to sell enough of the ISOs to pay for the cost of exercising the options, converting the remaining ISOs into shares of stock and holding the stock until a future date.  Assuming the company stock has increased in value since your incentive stock options were awarded, you can sell a portion and take the profits to pay for the remaining shares.

For example, by selling 100 shares @ $100 each, you will receive $10,000, enough funds to pay for all 1000 shares. After selling the 100 shares, you will own the 900 remaining shares.

5 – When Should I Exercise My Incentive Stock Options?

There are a number of factors that affect when you should exercise your ISOs. Again, this is a topic where a financial expert can be invaluable.

Of course, you’ll only be eligible to exercise your ISOs once they have vested. Fortunately, you are allowed to exercise the options as soon as they vest, in most circumstances.

In our earlier example, where 1000 ISOs vested 20% per year over five years, after year one, you would be eligible to exercise 200 ISOs (1000 x 20% = 200).

If the company’s stock has gone up since you were granted the ISO, it may make good sense to exercise the vested options, selling the shares in a cashless transaction and reaping the profits. Some factors that come into play in this decision include whether you need the funds in the near term, whether you’re concerned for the long-term health of the economy, general stock market trends, future prospects of the company, among others.

However, if you have confidence the company will continue to grow and the share price will continue to go up, you can consider waiting for a period of time before exercising your vested options.

Here’s a special circumstance to keep in mind. If you are deemed a company insider, that is, an executive with knowledge of the company’s strategic plans or potential future earnings, you may only be able to exercise options (or sell common stock) during what’s called a trading window, typically in the middle of a given fiscal quarter.  If you know you are an insider or you think you may be, you may want to consult your legal department before you do anything with your options.  This helps protect other shareholders who invest in the company but do not have access to the same level of information as company insiders.

6 – Should I Exercise My ISOs As Soon As They Vest, Or Wait?

When to exercise your ISOs is a judgment call based on a number of factors. First, do you have strong confidence that the company will continue to grow its revenues and, thus, its share price? Remember that often there are macroeconomic factors outside the company’s control that impact whether a company’s stock increases or decreases in value. Trying to predict the future always comes with risk.

Do you need the money now? Are there debts, college funds, a home down payment or other compelling factors that require immediate access to the funds? If so, exercising the ISOs and taking the associated profits can make good financial sense.

If your ISOs and perhaps employee stock purchases represent the lion’s share of your investment portfolio, diversifying your money by exercising your options and moving the profits to other investment vehicles may help protect your long-term financial prospects.

 7 – What are the Tax Implications of Incentive Stock Options?

When exercising ISOs, there are two primary possible tax treatments, called qualifying distributions and disqualifying distributions.

Qualifying distributions may help minimize your tax liability. Qualifying distributions apply when the final sale of the stock occurs at least two years after the option grant date and at least a year after the exercise date.

As a result, your entire profit from the transaction is taxed at long-term capital gains rates, 0%, 15% or 20%, rather than as ordinary income, likely a higher rate.  (Higher-income earners may also owe the 3.8% Medicare surtax on the net investment income.)

Disqualifying distributions occur when you exercise your options in any other way that does not meet the standard for qualifying disposition. One potential benefit of this approach is you have access to the funds from the stocks you sell. This helps protect you against a possible drop in the stock price while waiting to sell and you’ll know how much profit to expect from the transaction.

When you exercise your ISOs, the profit, or spread, is treated as income for alternative minimum tax (AMT) purposes. This could trigger having to paying the AMT in that tax year.

It’s helpful to be familiar with the various tax forms that are commonly associated with incentive stock options. For example, ISOs are reported on Form 1040. You may have ordinary income, capital gains (or losses), or both, which will be reported on your 1040 tax return.

Your Form W-2 will include any compensation income received from your employer shown on your W-2, including your income from ISOs upon selling your stock.

You will receive a Form 1099-B the year you sell your ISO stock shares. It reports capital gain or loss on your tax return.

Your employers will also provide a Form 3921 (Exercise of Incentive Stock Options) for the year you exercise ISOs. Information on the form will help you determine AMT, if applicable.

In the event you are required to pay the Alternative Minimum Tax from profits from selling ISO shares , you will need to file Form 6251 (Alternative Minimum Tax), which you use to report AMT from the exercise of incentive stock options.

If you have a financial advisor or tax accountant, they will be very familiar with these forms and can help you properly prepare your filings.

Moving Forward with Your Incentive Stock Options

Incentive stock options are a powerful tool that may help create great wealth. The more successful the company is, the more options you have, and the lower the exercise price, the more you may stand to gain as the company’s stock price climbs.

They are also potentially complicated compensation vehicles that integrate advanced tax, investment, and personal financial planning goals.  This is why it often takes a specialist in equity compensation or, more likely, a team of individuals to help plan for a suitable outcome.

This leads to the fact that there are a number of important decisions to consider when developing your financial strategy around your ISOs. It’s important to find an expert to help guide you, saving you money, time and possible tax liabilities down the road.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

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An employee stock purchase plan is a compensation tool that may allow you to purchase shares of company stock through convenient payroll deductions.

Employee stock purchase plans, or ESPPs, can give you the opportunity to buy company stock at a discount or at a favorable price. Through the plan, you could also receive potentially preferential tax treatment on the profits should you meet specific holding periods requirements for the shares you buy.

If your employer offers an ESPP but you’re not sure if you should participate, here’s what to know to help you decide whether or not you’d like to take advantage.

1 – You Buy Shares of Company Stock Through an ESPP

An employee stock purchase plan allows you to buy shares of company stock. Owning shares of company stock may be a good thing if you think the company stock price will go up, but it comes with a number of risks.

The most obvious risk is one all investments carry: there’s a risk of loss, as there’s no guarantee your investment will increase in value. There’s a chance you could buy shares, hold them, and see their price fall below what you paid for them.

But there’s another risk that not every other investment carries, and that is concentration risk.

Before you participate in your ESPP, and especially if you plan to participate and hold the stock you buy (instead of immediately selling the shares to lock in any discount you may receive), you need to know what it means to hold a single stock position.

You also need to consider that not only do you hold company stock, but your employer pays your salary — so if something happens to the business, both your investments and your cash flow could be negatively impacted.

2 – You Usually Fund an Employee Stock Purchase Plan with Payroll Deductions

Most employee stock purchase plans are set up so that enrolling into one allows you to elect to defer a set percentage or amount of your paycheck to the plan.

This makes contributions easy and convenient, which many employees see as an attractive feature of ESPPs. Just keep in mind that the plan comes with an annual contribution maximum of $25,000 per year.

Once you enroll, your employer automatically deducts a portion of your paycheck into the ESPP much like 401(k) contributions are deducted from your pay. But unlike a traditional 401(k) where you fund the plan with pre-tax deferrals, ESPP contributions are made with after-tax money.

Contributions from payroll can be likely be turned on and off at set intervals per the rules of your plan document.

3 – Purchases in an Employee Stock Purchase Plan Are Made at Set intervals

Many plans provide an “offering period.” During this window, your employer collects your payroll contributions and holds them in a trust.

Your plan will also have a purchase date. On the purchase date, your employer uses the funds collected during the offering period and held in the trust to buy shares of stock.

For example, your plan may have an offering period of 2 years and a purchase date of every 6 months. This means that you may be eligible to participate in the plan for 2 years. During that 2-year period, there will be 4 times during which shares will actually be purchased:

  • At 6 months
  • At 12 months
  • At 18 months
  • At 24 months

From months 0 to 6, your contributions go into a trust until the purchase date at the 6-month mark. At that time, your employer uses the funds to purchase shares for you.

Contributions accumulate in the trust again for another 6 months, until the 12-month purchase date when your employer buys shares. This process will continue until the end of your 2-year offering period.

4 – You May Have a Beneficial “Lookback” Provision 

The actual purchase price you pay for the shares you purchase through your ESPP is subject to your plan document.

For some plans, the price you pay will be the fair market value on the stock on the purchase date. For others, you should check to see if your plan allows for a lookback provision.

A lookback provision allows for an ESPP to purchase shares of stock at the purchase date price or the grant date price, whichever is lower. The grant date price is typically the price of the stock on when the offering period begins.

For example, say the grant date price for your employee stock purchase plan shares was $100 per share and the purchase date price was something like $150 per share. Over the last 6 months, if you’re set to max out how much you can contribute, you would have put $12,500 into your plan.

If you have a lookback provision, here’s how your ESPP could purchase these shares on your behalf at the offering date price:

Payroll Deductions Collected / Offering Date Price = Shares Purchased

$12,500 / $100 = 125 shares

Shares Purchased x Purchase Date Price = Current Value

125 x $150 = $18,750

In this scenario, you will have contributed and paid $12,500 for something that is immediately worth $18,750.  You will have benefited from “free” stock price appreciation during the 6-month period.

If the stock price went down — let’s say it dropped from $100 to $50 per share — you will be able to buy the same 125 shares at $50 per share purchase date price.

5 – Your Employee Stock Purchase Plan May Allow You to Buy at a Discount

Many employee stock purchase plans will offer a discount of up to 15% on the purchase of company stock. Being able to buy something at a 15% discount that you can immediately sell for full market value means locking in a profit of at least 15%.

Remember to check your plan document to confirm whether or not you receive such a discount. Not all plans are the same, and some don’t offer this ability to buy at a discount (or the percentage of that discount might be something other than 15%).

A 15% discount can be even more beneficial if you can combine it with the lookback provision. In our example above, let’s assume that the stock price has gone up and you paid $100 per share for shares that are currently valued at $150 per share.

If your plan offers a $15 discount, you will actually pay $100 per share less 15%, or $85 dollars per share. In the example when the price drops during the offering period, you will pay $50 per share less 15%, or $42.50 per share.

6 – You May Pay Several Types of Tax When You Sell Your Shares

When you purchase shares of company stock through an employee stock purchase plan, you pay no tax. But when you sell those shares, you create a reportable event for tax purposes.

The type of tax you pay will depend on how long you held the ESPP shares. More specifically, the sale of your ESPP shares will be identified as a qualifying or disqualifying disposition.

A qualifying sale is one that meets the following criteria:

  • The final sale occurs at least 2 years after the offer date
  • The final sale occurs at least 1 year after the purchase date

Anything that does not meet these criteria is a disqualifying disposition.

The tax rules for an ESPP can be complicated. You’ll likely find yourself reporting a combination of compensation income and short- or long-term capital gains income, depending on the offering period price, purchase date price, and how long you held the shares since the purchase date.

Generally speaking, if you have a qualifying disposition, the discount received from the offering date price will likely be taxed as compensation income and taxed at your regular tax rates.

However, if you have a total realized gain at sale that is less than the discount, your compensation income may be lower. Gains, if any, in excess of the offering date price (not including the discount) will likely be taxed as a long-term capital gain.

If you have a disqualifying disposition, you’ll likely report compensation income on the discount received from the actual purchase price paid and short- or long-term capital gain/loss on anything in excess.

7 – Everything You Need to Know Lives in Your Employee Stock Purchase Plan Document

You’ve seen in here a few times, but I encourage you to obtain a copy of your plan document.  This document will tell you the specifics of your plan.

By consulting the plan document, you can find out if you get to buy shares at a discount or not, and if your plan offers additional benefits like a lookback provision. The plan document will also detail when and how to enroll and when and how you can sell your shares.

If you still aren’t sure of the answers to your questions after you read it, it make may sense to talk with a professional who can help you navigate this potentially complex topic.

Your Employee Stock Purchase Plan May Be a Great Deal

As you can see, there are a lot of moving parts with an employee stock purchase plan. It can get complex, but if you have access to this kind of company benefit you may want to take advantage.

You’ll want to be sure this strategy, however, fits into your overall financial plan and investment allocation. It also needs to fit within your cash flow, because the money to fund the ESPP comes directly from your paycheck.

If you can buy shares at a discount, benefit from a lookback period, and sell the shares immediately after purchase — while also managing the change in cash flow as some money from your paycheck will go straight into the plan — an ESPP may allow for you to capture immediate profit with little to no risk.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.  Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

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Finance and Flip Flops by Daniel Zajac, Cfp®, Aif®, Clu® - 2M ago

If you have incentive stock options, you’ve likely heard of — and perhaps already paid — the alternative minimum tax. This is the tax due in the years you exercise and hold incentive stock options, or ISOs.

You might also be entitled to an AMT tax credit if that’s the case. The AMT credit gives you the ability to get back some or all of the AMT you paid when you sell your incentive stock option shares in a final sale.

Unfortunately, the AMT you pay and the AMT credit you might receive don’t always line up in a dollar-for-dollar offset.

If you sold your ISO shares, you may not have received the full AMT amount you paid in the form of a credit. Instead, you could have what’s known as a carryforward AMT credit.

A portion of the carryforward AMT credit will likely trickle back to you each year until the carryforward is fully exhausted, assuming you’re working and have wage income.

But what if you already retired and no longer have wage income to report?

Capturing the AMT credit can get more complicated in this case, and might warrant a change in your retirement income distribution strategy.

Here’s what you need to know.

A Review of One Retirement Income Distribution Strategy

“Where will my retirement income come from?” is a very common retirement planning question. Going from a reliable paycheck to an uncertain income stream is often a big hurdle for a new retiree to overcome.

While the process of distributing monthly income from investment accounts to mimic a paycheck is reasonably simple, the strategy behind the implementation isn’t always so straightforward.

One generally-accepted practice for taking retirement income is to distribute non-IRA money first, followed by tax deferred IRAs second, and Roth IRAs last.

This distribution technique is often an attempt to keep your income tax low and allow you to leverage tax-deferred growth for as long as possible. Some retirees can use distributions from a non-IRA so successfully that they don’t owe income tax at all — and that’s usually a good thing.

But depending on the particulars of your situation, it could also be a missed opportunity if you don’t “fill up” low income tax brackets by forcing taxable income from IRA distributions. The benefit of filling up low income tax brackets is the ability to take money out of taxable accounts a 0%, 10%, 15%, money that may otherwise be taxed at 20% or more if you take it out later.

This creative retirement income planning can be further complicated in your low taxable income retirement years if you also have a carry-forward AMT credit as the result of previously held incentive stock options.

If you have a carry-forward AMT credit, you likely need taxable income in order to get your AMT credit back– which means assuming you should follow the standard strategy and take your retirement income distributions from a non-IRA first, then an IRA second, then a ROTH IRA last might not be a good idea.

The Problem for the AMT Credit: Zero Taxable Income May Mean Zero AMT Credit

If you follow the standard process above and fund your retirement with distributions from a non-IRA account, you’ll likely need to sell investments within an account to create the necessary distributions.

When you sell investments, the amount that will be taxable will likely be equal to the difference between the cost basis (what you paid for the investments) and the final sale price (what you sell the investments for when you need to use the money).

Generally speaking, you will have one of the following outcomes:

  • If the cost basis is lower than the final sales price = reportable taxable income
  • If the cost basis is equal to the final sales price = no reportable income
  • If the cost basis that is greater than the final sales price = reportable capital loss

Whether you receive short- or long-term capital gains tax rates on the proceeds will affect the amount of taxes you pay, as well — and if you’re too good at creating (or limiting) taxable income that you generate zero taxable income, both your regular tax and your tentative minimum tax may also be zero.

The potential negative of zero taxable income is that there is no opportunity for an AMT credit that year. Because no income means no credit, you essentially defer the credit that may otherwise be due to you.

How to Force Taxable Income to Receive Your AMT Credit

How do you create taxable income during these low (reportable) income years — and more importantly, how do you know if it makes sense to do so?

One simple way to create taxable income is to take an IRA distribution. Generally speaking, an IRA distribution will be taxed as ordinary income in the year it is received.

Let’s look at an example of a single taxpaying using the standard deduction in 2019. Using Lacerte tax planning software, we know the total federal tax due if the only reportable income is  a $100,000 IRA distribution, is $15,253.

$15,253 is a lot of money. You may wonder why you would deliberately force this into taxable income if the other option is to pay no income tax at all.

For one thing, a 15% tax rate is relatively reasonable. For another, you may pay even less than $15,253 if you factor in what is owed to you through the carryforward AMT credit.

We can continue this example to illustrate when forcing taxable income might make sense. Let’s continue the assumptions we’ve worked with so far, and also assume you retired with $200,000 worth of carryforward AMT credit.

When you calculate your tax return, your regular tax will still be $15,253. You also have a tentative minimum tax (TMT) of $ $7,358, and this is the tax calculation used to determine if and when you get your AMT credit back.

If you have carryforward AMT credit and your TMT is lower than your regular tax, you may be eligible for the AMT tax credit.

In this example, the AMT credit will be the difference between the regular tax and tentative tax, or $7,895. Your taxes due in this situation is $15,253 of regular tax, less $7,895 of AMT credit — or $7,358. Your carryforward credit then adjusts to $200,000 less $7,895, or $192,105.

Because of your ability to leverage the AMT credit in this example, a $100,000 distribution of IRA assets cost only $7,358 in tax, or 7.36%.

What If You Don’t Need the IRA Money?

All this being said, you may not want to force IRA distributions, even if they are at a favorable 7.36% average tax rate, if you have non-IRA assets you can use to fund your retirement. There’s still a reason to consider making this move even in this case, though.

Creative planning, like using Roth conversions, may make sense in low-income retirement years. In lieu of taking the IRA distribution as cash to spend, you can process the distribution as a Roth conversion.

It would look like this:

  • You transfer $100,000 into a Roth IRA via a Roth conversion.
  • You report $100,000 of taxable income.
  • You pay tax on the $100,000 (assuming a 15% rate and the AMT credit, that’s $7,358).
  • The money in the Roth continues to grow tax-deferred and will eventually be income tax free (assuming certain conditions are met).
The Impact of 10 Years of Roth Conversions Coupled with the AMT Credit

We already looked at how to secure a low tax bill on a $100,000 distribution if you have an AMT credit and a $100,000 IRA distribution.

But that just illustrated a single year. This strategy might look even more appealing when you see the financial impact of forcing taxable income via a Roth conversion coupled with the capturing the AMT credit can have over a decade.

Assume that you process a Roth conversion of $100,000 per year for 10 years and the annual federal tax cost (per our example above) is only $7,358. Let’s also assume that the money in the newly established Roth IRA earns 7% per year.

Here’s what the numbers look like when you run them out over 10 years:

  • Total Income Taxes Paid: $73,580
  • Total AMT Credit Used: $78,950
  • Remaining AMT Credit: $121,050
  • Future Roth IRA Value: $1,478,360

If you know how to use your AMT credit effectively in retirement, you can create a tax-deferred and income tax free bucket of nearly 1.5 million dollars at a tax “cost” of just $73,580.

The fact that Roth IRAs are not RMD eligible makes this an even better deal.  You took $1.5 million of IRA dollars that would be subject to RMDs and moved them into an account that is RMD-free.

Using the AMT Credit in Retirement

Retirement income planning can be complicated in even the simplest scenario. It gets even more complicated when you add advanced tax planning and the AMT credit. But that complication may lead to opportunity for those versed with the knowledge.

If you transition into retirement with potentially low-income tax years and a carryforward AMT credit, it may be overly simplified to assume you should take distributions from a non-IRA first, then an IRA second, then a Roth IRA last.

If you follow this shortsighted track, you may be missing the opportunity to effectively utilize your AMT credit in the short and long term in a meaningful way.

By completing a bit of advanced tax, investment, and cash flow planning, you can develop a strategy that effectively accelerates some of your AMT credit sooner rather than later, and allows you to effectively reallocate your assets in a more tax efficient manner.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

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Want to pay less in taxes from the sale of your incentive stock options? While you can’t completely avoid taxes on a profit when you exercise and sell shares from ISOs, you can potentially earn the right to pay at long-term capital gains tax rates — which are lower than ordinary income.

This potential for paying a lower tax rate is one feature that tends to make incentive stock options more favorable than their non-qualified stock option counterpart.

But how do you secure that lower rate? You need a qualifying disposition, which you can secure if you meet both of the following standards:

  1. The final sale of the stock occurs at least 2 years past the grant date.
  2. The final sale of the stock occurs at least 1 year past the exercise date.

If you meet these two standards, the total realized profit between the grant price and the final sales price (times the number of shares sold) is subject to long-term capital gains tax.

Think Beyond Taxes Before Deciding on a Strategy for Exercising Incentive Stock Options

The allure of this potentially lower income tax treatment can be a strong motivator in seeking a qualifying disposition. But receiving preferential tax treatment is not the only option nor the only thing to consider when choosing a strategy for exercising ISOs and selling shares.

Anything that is not a qualifying disposition is a disqualifying disposition. With a disqualifying disposition, a portion of the profit may be subject to ordinary income tax rates and a portion may be subject to short- or long-term capital gains tax rates.

A disqualifying disposition will likely leave you with a different tax liability than a qualifying disposition, but that’s not a bad thing.

In fact, in some scenarios it might make more sense to intentionally do a disqualifying disposition, even while knowing that you won’t secure a long-term capital gains tax rate on your entire profit.

Here are a few reasons why you might intentionally choose a strategy for ISOs that ends in a disqualifying disposition.

Reason 1: A Disqualifying Position Allows to You Immediately Capture Potential Profits

When you exercise and hold incentive stock options with the intention of doing a qualifying disposition, you must hold the stock shares for at least 1 year past the exercise date. During this time, you are subject to the risk-reward tradeoff of owning a single stock position.

Because of this holding period requirement in which you can’t sell your shares, you don’t realize any profit (even if the share price goes up during this time). The value may change as the share price fluctuates, but it’s all unrealized losses or gains.

Only when you sell the shares do you realize a profit — if the price of the shares rose higher than the exercise price. But that’s a big “if,” which is why holding the shares in an attempt to achieve a qualifying disposition comes with risk.

If you do a disqualifying disposition whereby you exercise the incentive stock option and immediately sell the shares, you actually capture the value right away. You won’t be subject to the daily ups and downs of the stock price, or the risk that the eventual share price drops below the exercise price.

You take the unrealized profit on paper and turned it into cash you can actually use, making a disqualifying disposition an attractive technique if your primary goal is to capture profit immediately without subjecting yourself to the risk of a drop in the share’s value and price.

Reason 2: A Disqualifying Disposition May Help You Manage Cash Flow

When you exercise and hold incentive stock options past the calendar year-end, you will likely be subject to 2 cash calls:

  1. The cash required to buy the shares, and
  2. The cash required to pay the alternative minimum tax (AMT)

The cash required to buy the shares of stock is equal to:

“Exercise Price” X “Number of Shares Exercised”

In our example below this is equal to $10,000. If you have a greater number of options or a higher exercise price (or both), your cash call could be significantly higher.

The cash required to pay the alternative minimum tax is more complicated because it’s based on a number of personal tax return inputs. One of those inputs is related to the bargain element of your ISOs. The bargain element is equal to:

(“Market Price at Exercise” – “Exercise Price”) X “Number of ISOs Exercised”

The larger the bargain element, the greater the potential for the AMT. The greater the AMT, the greater the potential for cash flow issues when it’s time to pay that tax bill.

We can use a couple scenarios to show this. For the first, assume that you have the following grant of incentive stock options:

  • ISO shares: 10,000
  • Exercise price: $1.00/share
  • Market Price at Exercise: $50
  • AMT Rate: 28%

If you exercise and hold all 10,000 incentive stock options shares, the bargain element and subsequent AMT due will be:

(“Market Price at Exercise” – “Exercise Price”) X “Number of ISOs Exercised”

($50 – $1) x 10,000 = $490,000

“Bargain Element” X “AMT Rate” = “AMT Due”

$490,000 x .28 = $137,200

That means you need $137,200 additional in cash to pay that tax bill. Herein lies the issue: where does the money come from to pay for the AMT due?

One way to cover the $137,200 cost of the AMT is to write a check from your other personal assets, if you have that type of cash available. Not everyone does (or if they do, they don’t want to use it to pay taxes), so a second option might be to do a disqualifying disposition of the incentive stock option shares.

Let’s look at a second scenario in which, instead of exercising and holding 10,000 incentive stock option shares, you exercise and hold 7,000 shares and exercise and immediately sell 3,000 shares.

When you sell the shares, you’ll immediately capture the profit from the sale:

(“Market Price at Exercise – Exercise Price) x “Shares Exercised and Sold”

($50 – $1) x 3,000 = $147,000

If you exercise and hold 10,000 shares, you need to come up with enough cash to pay the AMT. In this scenario when you exercise and hold 7,000 shares — but also and exercise and sell 3,000 — you’ve created a positive inflow of $147,000 that can be used to pay the tax bill.

Reason 3: You Might Owe the Same in Taxes Regardless of Disposition Type

Many people don’t want to end up with a disqualifying disposition because they believe they’ll pay significantly more income tax this way. But that’s not always the case.

The way your taxes are calculated are different depending on whether you have a qualifying or disqualifying disposition. But in some cases, the amount of taxes owed can be very close.

When you exercise and sell as a disqualifying disposition, your income tax calculation will likely include two parts. The first part is the profit from the exercise and sell.

This profit will likely be subject to ordinary income tax. If we follow scenario 2 above with 3,000 shares as a disqualifying disposition, the profit of $147,000 will be subject to ordinary income. If we assume at 32% income tax rate, the total tax due will be $47,040.

A disqualifying disposition of some of the shares also means that the AMT adjustment for the remaining exercised and held shares will be lower than had you exercised and held all the shares.

In scenario 1 above, the bargain element when you held 10,000 shares is $490,000. In scenario 2, only 7,000 shares were exercised and held. These make up part 2 of the tax calculation.

The bargain element is:

(“Market Price at Exercise” – “Exercise Price”) x “Shares Exercised and Held”

($50 – $1) x 7,000

= $343,000

Assuming a flat 28% flat AMT tax rate, the AMT due (our part 2) will be $96,040. If we add these two taxes together, the total tax from the original 10,000 shares will be $143,080.

Compare that to the example above when you exercised and held 10,000 shares and the total tax due was $137,200.

The difference in total tax due for this calendar year is under $6,000, which is a relatively small amount compared to all the numbers we’re using here.

When you owe a similar amount in taxes either way, a disqualifying disposition may make more sense because you don’t subject yourself to the risks of holding a single concentrated stock position.

That being said, you may want to work with an accountant or an advisor who can model the two for you to see what it may look like in your specific situation before making a decision.

Reason 4: A Disqualifying Disposition Could Lead to a Reduced Position in Company Stock

If you are seeking to reduce your position in company stock, an intentional disqualifying disposition is one way to do so.

Looking back at the examples above, the end result of scenario 1 is owning 10,000 shares of company stock valued at $500,000. The end result of scenario 2 is owning 7,000 shares valued at $350,000. That’s a 30% reduction in exposure to the company stock by using a disqualifying disposition.

This could be an important consideration if you have a large portion of your net worth already tied up in one company stock, you want to retire and need to diversify, or you otherwise feel as though the stock price has peaked.

But if you are bullish on the stock, adequately understand the risk/reward tradeoff, and/or have other assets or means on which to survive, you might deliberately choose to own a large position in the stock.

You need to determine how much concentration risk is appropriate for you to take on, which should be considered in the larger context of your comprehensive financial plan.

Reason 5: You May Still Be Able to Participate in the Upside of the Company Stock

Many people feel influenced to act one way or another because they fear missing out. As this pertains to owning company stock, you might feel the fear of selling your stock shares too soon (even if it’s a profit) and missing out on being part of a potential meteoric rise if the company becomes “the next Apple.”

This isn’t a reason to avoid a disqualifying disposition, though. Using this strategy to sell some of your shares may still allow you to participate in the upside of the company.

Again, using our example, in scenario 1 you retain 10,000 shares and in scenario 2 you retain 7,000 shares. If the stock price quadruples from $50 per share to $200 per share, the value of your 10,000 shares will be $2,000,000 and the value of your 7,000 will be $1,400,000.

Clearly there is meaningful difference between these two figures (30%). But even in scenario 2, you very much benefitted from and participated in the growth of the value of the company and did not miss out on much.

Is a Disqualifying Disposition A Good Idea?

A disqualifying disposition may be a good technique to implement a part of a liquidation strategy for your incentive stock options.

It could help you create positive cash flow that can be used to offset the tax liability, manage your position in one stock while still allowing for participation in the upside, or capture profits immediately (instead of leaving that to chance) along the way.

These reasons are why it may make sense to explore how exercising and selling shares from ISOs as a disqualifying disposition fits into your overall plan, as compared to blindly seeking a qualifying disposition in an effort to pay long-term capital gains rates instead of a potentially higher ordinary income tax rate.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. All investments are subject to risk, including the risk of principal loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

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Restricted stock units are commonly used as a compensation tool by employers who want to reward and retain key employees.

If you’re on the receiving end of restricted stock units, or RSUs, you could be set to financially benefit if you meet specific conditions set by your employer. The requisite condition is often staying employed with your company for a stated period of time.

If you meet length-of-time condition, your RSUs vest and the value of the restricted stock units become yours. The value can be settled in shares of stock or in cash.

Restricted stock units can be more valuable to you if the company stock price increases between the grant date and the vesting date. When the RSUs vest, you receive a value equal to the stock price on the vesting date times the number of units vested. A higher stock price, all else being equal, means a higher value for you.

A shared desire for an appreciating stock price is why both employers and employees may find restricted stock units attractive. The employer benefits from happy employees working hard in the company to maximize a future benefit. As the employee, you could benefit from an increasing stock price.

It can be a great win-win scenario, but you have to understand the ins and outs of your RSUs if you want to make the most of them.

Here’s how to understand what happens when your employer grants RSUs, what happens when they vest, and how you can plan to manage the resulting stock value in the scope of your larger financial plan.

The Grant and Vesting of Restricted Stock Units

Generally speaking, when you receive restricted stock units:

  • You have no legal right to the value of the units.
  • The value is not taxed (unless you use an 83(b) election, then you will be taxed when you receive the stock and not when the units vest).
  • If you leave your company, you will forfeit any future benefit or value.

As the name suggests, your restricted stock units are, in fact, restricted.

When the restriction is met and the restricted stock units vest, a taxable event occurs. You will be required to report taxable income equal to:

(Number of Shares Vested * Market Value at Vest) = Taxable Income

Following the vesting of your restricted stock units and the payment of taxes, you’ll often receive shares of company stock. But remember that not all restricted stock units settle in shares of stock. Check your plan document to see exactly what you will receive and the specific rules around your RSUs.

Know What You Will Receive When your Restricted Stock Units Vest

When your restricted stock units vest, you will be entitled to receive the vested value of your units. For some plans, the value of restricted stock units will be paid in shares of company stock. For others, the value will be paid to you in cash.

How this value is paid will be subject to the terms of your plan document; look for settlement options to find this information.

To illustrate how this might work, let’s assume you have the following:

  • Number of Restricted Stock Units: 1,000
  • Market Price of Each Unit on the Vesting Date: $50.00
  • Tax Withholding: 22%

If we assume your restricted stock units will settle in shares and that a cashless exercise that allows you to pay the corresponding income tax bill by immediately selling some of the vesting restricted stock units, we can calculate how many shares you will retain after the RSUs vest:

(Number of Shares Vested * Market Value at Vest) = Taxable Income

1,000 * $50 = $50,000

(Taxable Income * Tax Withholding) = Tax Due

$50,000 x 22% = $11,000

(Tax Due x Market Price at Vest) = Shares Required for Cashless

$11,000 x $50 = 220 Shares

(Restricted Stock Units Vested – Shares Required for Cashless) = Shares Held

1,000 – 220 = 780 Shares Held

Post-vesting and post-tax withholding, you retain 780 shares of stock with a current market value of $39,000.

If your restricted stock units settle in cash, your company will pay you $39,000 cash in lieu of 780 shares of stock.

Have You Withheld Enough from Your Restricted Stock Units for Income Tax?

While many companies will have a statutory tax withholding rate they will require when restricted stock units vest, there’s no guarantee made by your company that the withholding rate will be enough to cover your actual taxes owed.

For example, if you withhold at 22% but your actual tax rate is 32%, you may find yourself owing tax when you file your tax return. On the other hand, if your overall tax rate is less than 22%, you may be entitled to a refund.

If you are ahead of the game in your planning, you can prepare a projected tax return to see the impact of vesting restricted stock units on your tax return. If you are unsure about how to do this, you may want to consider the services of a good accountant or financial advisor.

What Will You Do with Your Remaining Shares?

If your restricted stock units settle in cash, you can use that cash in a number of ways to help meet your financial goals.  You could buy into a diversified investment portfolio, use the cash to pay down debt, or add it to your cash reserves.

You can even go buy more shares of company stock if you want. The options are seemingly endless (which is even more of a reason to plan ahead and know how you’ll leverage this opportunity).

If your restricted stock units settled in shares of company stock, there are other considerations to keep in mind. For one, you now have full ownership rights of stock. This means you are entitled to keep the shares, receive dividends (if any), vote on company related matters, etc.

Your ownership right also means that you can sell the shares of stock if you want. Just because you received company stock as part of your compensation does not need to mean to keep the shares, so you can always sell the shares and receive the proceeds as cash to create the same outcome as if the units settled in cash.

A Rolling Strategy to Manage Your Vested Restricted Stock

One strategy that may balance the decision to retain 100% of the shares or selling 100% is to implement a plan that suggests selling a certain number or percentage of shares over a set period of time.

In our example, this strategy could be implemented by planning to sell 25% of the shares over the next 4 years. If you did, the sale would look like this:

Calendar Year Shares Sold
Year 1 195
Year 2 195
Year 3 195
Year 4 195

After the 4 year period, you will retain 0 shares of company stock.

If the stock price goes up during the 4-year period, you will participate in some of the upside as you still retain shares for 4 years (albeit as a smaller amount).

Calendar Year Shares Sold Stock Price Value of Sale
Year 1 195 $60 $11,700
Year 2 195 $72 $14,040
Year 3 195 $86.40 $16,848
Year 4 195 $103.68 $20,218
Total Proceeds $62,806

Had you held 780 shares until the price reached $103.68 per share, the total proceeds would be $80,870.

If the stock price goes down during the 4- year period, you will participate in some of the loss, but not as much as you would have had you retained all the shares.

Calendar Year Shares Sold Stock Price Value of Sale
Year 1 195 $40 $7,800
Year 2 195 $32 $6,240
Year 3 195 $25.60 $4,992
Year 4 195 $20.48 $3,994
Total Proceeds $23,206

Had you held 780 shares until the price dropped to $20.48 per share, your total profit would be $15,974. While this is obviously a smaller amount than you would have received had the stock price gone up instead of down, you still gain something and benefit from having RSUs and taking action with them.

This strategy allows you to intentionally reduce your company stock based on a set schedule. That’s a good thing because it means you don’t have to guess at what the stock price will do next, or say you will sell when the price reaches X per share, only to change your plans once the price does hit that point (and then risk the price going back down before you do sell).

This sell-on-a-set-schedule approach is a deliberate, intentional, and systematic process to manage your stock position in a way that allows you to participate in the upside and manage the downside.

What to Do Now with Your Restricted Stock Units

If you own restricted stock units, you need to plan for what you will do when they vest. If you have RSUs that have already vested and you own the shares outright, you should also consider how they fit into your overall financial plan.

Understanding the strategy you’ll use — and then implementing it — is critical to making the right moves for your situation. Whether you retain your RSUs or sell them when they vest, being prepared will help you be proactive instead of reactive and make the most of the opportunity these units may provide.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

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Even if you don’t have plans to leave anytime soon, it’s not unreasonable to consider what happens to your employee stock options when no longer work for your current employer.

Whether due to a planned retirement after a long career, a new opportunity at another company, or an intentional sabbatical from the workforce, there are plenty of good reasons why you won’t be at your company forever.

There are also less-desirable circumstances under which you might leave. While no one hopes or plans to be let go, fired, or forced to stop working for a negative reason, these things do happen.

Either way, for better or worse, it’s important to know what happens to your employee stock options upon terminating your relationship with your employer.

The answer to what happens can get complicated. Depending on why your employment status changes from employee to former employee and what type(s) of employee stock option(s) you have, the rules surrounding what you can and can’t do with your equity compensation will vary.

The best strategy is to check your plan document for the specific rules regarding your plan. But in the meantime, here is a primer of things to know now.

The Basics of Employee Stock Options When You Terminate Your Employment

Employee stock options are issued with an expiration date. The expiration date is important because it lets you know the last day you can capture the value of employee stock options via an exercise.

The expiration date is usually ten years from the grant date. However, every plan is subject to its own rules; again, you should check your plan document to determine specific details like this.

Regardless of when the date is, if you do not exercise and the expiration date comes and goes, your option will terminate and you will lose the ability to exercise. Subsequently, you forfeit any imbedded value. This happens even if you’re still employed with the company.

Your right to exercise your employee stock options may change, however, as your employment status changes. Generally speaking, if you are terminating your employment from your company, you will need to exercise your employee stock options at the earlier of the expiration date or the new expiration period set in the plan document for a terminated employee.

Change in employment status can be segmented into several categories:

  • Termination by choice
  • Termination by disability
  • Termination by death

Your plan document should help you determine what your post-termination expiration provisions are once you know the circumstances around your departure.

Vesting Stops When You Leave Your Company

Prior to getting into your post-termination exercise periods, you should know that when you leave the company for any reason, unvested shares remain unvested in almost all cases.

Practically speaking, this means that the in-the-money value of unvested employee stock options is forfeited. The negative impact to your net-worth statement of forfeiting potentially valuable unvested options may be material if you are considering termination employment.

Let’s assume that you have the following employee stock options

Grant Shares Vested Exercise Price FMV Total Value Vested Value
1 10,000 10,000 $1.00 $25.00 $240,000 $240,000
2 15,000 15,000 $2.00 $25.00 $345,000 $345,000
3 10,000 0 $3.00 $25.00 $220,000 $0.00
Totals 35,000 25,000 $805,000 $585,000

In this scenario, you have a total employee stock option value of $805,000 if we consider vested and unvested stock options.

Only 25,000 of the 35,000 options are vested here, meaning your current exercisable value is $585,000. That’s considerably lower than the total value of $805,000.

In order to obtain the full value, you have to stay employed with the company until the 10,000 options in Grant 3 vest. Assuming you do work until Grant 3 vests, you will have access to those shares as well. But if you terminate your employment prior to Grant 3 vesting, the value of Grant 3 goes away.

The decision to leave your employer when you know that it means forfeiting unvested options may be critically important in the financial planning process.

If I had a client who wanted to leave because they wanted to retire, for example, we might model out retirement income projections. As part of the projection, we need to know whether to include the $805,000 of total stock option value — or $585,000 of stock option value that could actually be realized and not forfeited before some of the shares vest.

That’s a $220,000 difference, which can make a big impact on how much you can spend in retirement.

If we assume a 3-5% withdrawal rate in retirement, its reasonable to assume that a retirement with only vested shares in this example may be between $6,600 and $11,000 less per year than what this client could spend in retirement per year if all the shares vested.

The timeline until your unvested shares vest is also important. If we assume that Grant 3 is scheduled to vest in the near term, it may make sense to work a little longer, allowing the shares to vest and you to capture the value.

Alternatively, if the shares do not vest for several years, the value of the unvested options is not an important part of your retirement plan, or both, then pulling the trigger to retire and forfeiting the option shares may be a better choice for you.

Exercise Timeline if You Leave to Take Another Job or Retire

If you leave your company voluntarily, either to retire, to take another job, or to take a break from work, you generally have up to 3 months or 90 days from your termination date to exercise your vested options. (As always, check your plan document as this period can be shorter or longer.)

Even if the expiration date of your employee stock options is further out in time than the 90-day exercise window, you must exercise within this new post-termination period.

However, if your original expiration date is after you terminate your employment but prior to the end of the 90-day post termination exercise window, you will need to exercise by that original expiration date to capture the value.

If you have incentive stock options, your post-termination exercise considerations may become even more complicated.

For an incentive stock option to retain its status as such, you must exercise the option within 90 days of termination of your company. This probably won’t be a problem if the 90-day period coincides with the requirement of the plan document.

But if your company gives you one year from termination to exercise your incentive stock options, you will need to exercise them within the 90-day post-termination period even though you have up to one year per the plan document in order to retain their status as incentive stock options.

Both an approaching expiration date and a change of employment status signify a point where you need to make decisions around your options. Choosing not to exercise means that you run the risk of losing the ability to capture in the money stock option value.

What Happens If You Become Disabled (or Worse, Die)?

Generally speaking, the timeline you have to exercise your employee stock options is longer if you become disabled than it is if you terminate for another reason. Often, you will have one year from the date you terminate employment to exercise your employee stock options.

If you have incentive stock options and become disabled, the 3-month post-termination exercise period is extended to 12 months. This allows for additional time to strategize the best way exercise your options and plan for the future.

Like the post-termination period if you become disabled, the post-termination exercise period for employee stock options if you die is longer than if you leave for another reason. Commonly, one year is used. But as always, you want to check your plan document to determine if your period is shorter or longer.

If you have incentive stock options, the rule that requires incentive stock options to be exercised within 3-months of job termination (or in this case, death) to retain status as an ISO is waived, so long as you were employed as of your date of death or within the 3 months preceding death.

Although certainly not ideal for most of us or our loved ones, from a strictly planning perspective, death offers the greatest flexibility in when and how to exercise your ISOs. It affords your estate (or its beneficiaries) the greatest time to strategize an exercise strategy that meets tax, investment, and financial planning needs.

Many plans will allow you to name a beneficiary of your employee stock options. This person may be able to act on your stock options upon death. They will have the right to exercise the options, sell the options, and/or received the stock shares themselves.

In lieu of a beneficiary, your personal representative in charge of handling your estate affairs will likely be able to assist in the exercise of the shares.

Before You Leave Your Company, Understand What Might Happen with Your Stock Options

When you leave your company, you likely have a short-term period during which you can exercise your remaining stock options. During this time, it’s a now-or-never proposition.

Exercise and capture the proceeds, or let them expire and lose what you have.

With that said, some advanced planning may be available to you. A first step is to check the document to know what timeframes you are dealing with. Know how long you have to exercise and how different circumstances for leaving might impact that timeline.

Next, plan and strategize for your incentive stock options. You might want to consider exercising within the 90-day period in order to retain the ISO status.

And finally, consider how your available exercise periods “wrap” around one calendar year or two. For example, if your 90-day exercise window is between November 1 of one year and January 31 of the next, you may be able to spread income over 2 years, which is helpful for tax purposes.

A good strategy will know the allowable timeframes and plan accordingly. This planning may include executing an early exercise of some (or all) of your options in an effort to avoid a significant singular tax bill due to a change of jobs.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

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If you have employee stock options, you’ve likely spent time considering how and when to turn the value of those options into cash proceeds you can actually use.

To turn stock employee stock options into cash, you have to exercise them.  When you exercise, you are buying shares of company stock at the exercise price of the employee stock option.

Buying shares of stock means that you still need to pay for them when you exercise — but you’re getting a bargain, because the price you pay will likely be lower than the current market price of the stock itself.

The exact cost to exercise equals the amount of shares you exercise multiplied by the exercise price of the stock option.

Understanding the Potential Costs of Exercising

Let’s assume you have the following:

Grant Shares Exercise Price FMV Exercise Cost Value
1 10,000 5.00 25.00 $50,000 $200,000

In this example, the exercise cost of 10,000 shares is $50,000.

However, you don’t have to exercise all your options at one time. If you only exercise 5,000 options (leaving you with 5,000 that can be exercised later), the exercise cost is $25,000, or 5,000 multiplied by $5 per share.

The same logic carries forward when you have multiple grants of stock options. For example, assume that you have the two employee stock option grants:

Grant Shares Exercise Price FMV Exercise Cost Value
1 10,000 5.00 25.00 $50,000 $200,000
2 5,000 8.00 25.00 $40,000 $85,000

The total exercise cost of both grants, or 15,000 shares, is $90,000. Again, you can choose to exercise a portion; you don’t have to exercise everything all at once. You can exercise only grant 1, for example, or only grant 2 — or some or all of each.

The kind of employee stock options you have may impact the cost of exercising, as well. This is because the exercise of an employee stock option is a taxable event.

In addition to the cost you pay to buy the shares, you may also need to pay tax. The type of tax you pay, when you pay it, and how much you pay will all depend on whether you have incentive stock options or non-qualified stock options.

Because of this it’s important to check your document and be sure of what kind of options you have before you take any actions with them. Checking in with a professional who can help you choose the right strategy might be a prudent move, as well.

Exercise Strategy 1 – Pay with Cash

A simple and clean way to pay the exercise cost is to pay with cash. With a cash exercise, you must deliver the cash required to pay the exercise cost when you exercise your options.

Doing a cash exercise may be a good strategy if you’re bullish on the future stock price of your company stock, and if you want to maximize the amount of shares you own.

If we assume that you exercise Grant 1 above, you will pay $50,000 to exercise the employee stock option. This $50,000 needs to come from assets you own already (like cash in a bank account).

Post exercise, you will own 10,000 shares outright — but you’ll have less money in the bank since you needed to use some cash on hand to buy the shares.

A cash exercise is effectively the opposite of diversification. This can be a good thing or a bad thing based on your goals, risk tolerance, and how the stock performs in the future.

Exercise Strategy 2 – Buy Using Shares Acquired via the Exercise Itself

A second strategy to exercise your employee stock options is cashless exercise (or a sell-to-cover). With a cashless exercise, you use newly acquired shares via the exercise itself to cover the exercise cost.

This is accomplished by giving instructions that request an immediate exercise and sell of enough shares to cover the cost of the exercise. You can retain whatever shares you didn’t need to sell to cover the cost of exercising.

If we looked at Grant 1 above, we can see the exercise cost is $50,000. In order to cover this exercise cost via cashless exercise, we need to calculate how many of the 10,000 shares must be sold immediately post exercise to pay for the exercise cost of the employee stock option.

The math to calculate the shares required is as follows:

“Cashless Shares Required” = “Exercise Cost” / “FMV at Exercise”

= $50,000 / $25

= 2,000

If you immediately exercise and sell 2,000 of your 10,000 shares, exercised at the current share price of $25/share, you will generate $50,000 of proceeds. You can use this $50,000 to cover the exercise cost.

That means you are left with 8,000 exercised shares that you hold outright. The post-exercise result of a cashless exercise is that you will own fewer shares than a you would with a cash exercise — but it also saves you from having to shell out $50,000 in cash.

A cashless exercise may be good for someone seeking to limit or diversify their company stock position. It may also be appropriate for someone who doesn’t have the requisite cash on hand to cover the exercise cost.

Exercise Strategy 3 – Use Previously Owned Shares of Stock via a Stock Swap

In addition to using cash or a cashless exercise to exercise your employee stock options, you can also use shares you already own to cover the exercise cost. You do this via a stock swap.

A stock swap allows you to exchange a sufficient number of shares you already own to cover the exercise cost of newly acquired shares from the stock option. You can use long-only shares, vested RSUs, exercised NQSOs, employee stock purchase plan shares, and exercised incentive stock options in stock swaps.

Each type of owned stock may have different rules that should be understood if being used for a swap, and you should consider the impact of each when before choosing a  strategy to implement.

When you do a stock swap, the original holding period and tax cost basis will transition to the swapped shares in a non-taxable event.  However, the exercise itself is a taxable event.

Let’s assume the following:

Grant/Share Shares Exercise Price FMV Exercise Cost Value
Long-Only 10,000 25.00 $250,000
NQSO 5,000 8.00 25.00 $40,000 $85,000

If the goal is to exercise 5,000 NQSOs, the cost to exercise will be $40,000. In lieu of paying cash or doing a cashless exercise, you can use some of your long-only shares to cover the cost.

To cover the $40,000 exercise cost, you will need to swap 1,600 long-only shares (1,600 x $25 per share equals $40,000).

Post-exercise, you will retain 8,400 long only shares and 5,000 NQSO shares, now owned outright. That gives you a total of 13,400 shares.

Like a cashless exercise, a stock swap means that you will typically own fewer shares post-exercise than you will with a cash exercise. A stock swap may be a good option for someone who is seeking to limit exposure to company stock.

Exercise Strategy 4 – Use a Combination of Strategies 1, 2, and 3

For any number of reasons, a singular strategy to implement only option 1, 2, or 3 may not be appropriate. The best exercise strategy for you might actually be a combination of strategies 1, 2, and 3 above.

This might be true even if you used one strategy over another in the past. Every time you exercise gives you an opportunity to implement a different strategy.

For example, you may choose to exercise lot 1 in our example via a cash exercise. A year later when you go to exercise lot 2, you may choose a stock swap.

Regardless of what you decide to do, you need to be aware of the tax implications of any exercise. Those implications alone can generate a separate, additional cash call when you exercise or when you file your tax return.

The Bottom Line on Exercising Your Employee Stock Options

If you are seeking to exercise your employee stock options, it means they are in the money and you capture real value. That the good news. To capture that value, however, you need to pay the exercise cost.

You can do that in a number of ways, using any (or a combination of) the strategies outlined above. Bear in mind, however, that any kind of exercise can lead to other complications.

Personal financial planning goals, your available assets, your short- and long-term opinions of the company stock, and the pending income tax implications may make exercising your ESO a daunting responsibility.

If you find yourself with unanswered questions about how to pay for your exercise, when to exercise, and how this all fits together, you may want to reach out to a professional who can help.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

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A stock swap can be a great strategy to use if you have employee stock options you’d like to exercise and hold. It allows you to use the fair market value (FMV) of company stock you already own to pay for the exercise cost of newly acquired employee stock option shares.

Shares you own that can be used for a stock swap can include those you’ve purchased on the open market, shares acquired from vested restricted stock units, shares you own from an exercise and hold of previous employee stock options, and/or shares acquired from and employee stock purchase plan.

But be aware that each type of share you use in a swap can generate some very different tax implications. It’s a good idea to work with a professional to ensure you choose a specific strategy that makes sense in the context of your overall financial situation.

The First Step to a Stock Swap: Check Your Plan Document

If you are considering a stock swap, the first step may be to check your plan document. While many plans allow for a stock swap, you’ll want to be sure yours is one of them.

If your plan document allows, a stock swap may make sense if you don’t have the cash available to do a cash exercise. It may also make sense if you are not seeking to maximize the amount of shares you own.

In fact, a stock swap will result in you having less value in company stock then you did prior to the exercise.

How a Stock Swap Works in the Real World

Let’s assume you own the following shares of company stock that you previously purchased on the open market. We will define these as long-only shares:

Long-Only Share Price Cost Basis / Share Total Value
10,000 $50.00 $20.00 $500,000

Let’s also assume that you want to exercise the following employee stock options, or ESOs. For sake of this immediate example, we will not distinguish between non-qualified stock options and incentive stock options (but we will cover each later in the article).

ESO Exercise Price Exercise Cost Current Share Price Total Value
5,000 $10.00 $50,000 $50.00 $250,000

The exercise cost of the ESO is $50,000. This cost can be paid for in a number of ways. You could do a cash exercise, a cashless exercise, or a stock swap.

If you are doing a stock swap, you pay the exercise cost of $50,000 by swapping the fair market value (FMV) of long-only shares equal to the exercise cost of the ESO.

If you held 10,000 long-only shares and wanted to exercise 5,000 ESOs, you will use fewer than 5,000 long-only shares to exercise and hold 5,000 employee stock options.

This is because you are using the FMV of long-only shares to buy ESO shares at the exercise price, which is lower than the FMV.

How many shares you need to swap is based on the spread between the FMV of the stock and the exercise price of the options:

Number of Shares Swapped = “Exercise Cost” / “Current Share Price”

=$50,000 / $50

= 1,000

You can swap 1,000 of your long-only shares to exercise the 5,000 employee stock options.

A swap is simply an additional way to exercise your options. More specifically, a stock swap may limit how many shares of stock you own and/or manage tax.

Stock Swaps and the Impact on Concentrated Equity

The end result of a stock swap is that you control fewer shares post-swap then you did pre-swap.

Prior to the stock swap, you had owned 10,000 long-only shares and the option to purchase 5,000 shares from the ESO. You “controlled” 15,000 shares.

After the stock swap, you have 9,000 long-only shares and 5,000 newly acquired shares from the exercise and hold of the ESO. You now “control” 14,000.

Because of this reduction in total shares controlled, a stock swap is one way to limit or decrease your concentrated equity position.  If may then make sense for someone who isn’t bullish on the stock or someone who wants to diversify their assets.

Comparing a Stock Swap to Other Exercise Methods

To evaluate whether a stock swap is a good idea or a bad idea, it makes sense to compare it to other exercise strategies. Two common strategies are a cash exercise and a cashless exercise.

A cash exercise may be a preferable strategy to stock swap if you are bullish on your company stock and want to retain as may shares as possible. With a cash exercise, you retain more shares post exercise than you do with a stock swap.

In our example, you will pay $50,000 to exercise and hold the ESO. Since you paid cash, you will retain the 10,000 long-only shares you own and pick up an additional 5,000 shares from the ESO, for a total of 15,000 shares. This is 1,000 shares more than the swap stock in our example.

The second option is a cashless exercise. If you are not bullish on your company stock, or want to diversify your concentrated position, a cashless exercise may be a better strategy for you.

In a cashless exercise, you use shares acquired via the exercise itself to cover the cost of the exercise. Continuing with numbers from our examples above, with a cashless exercise, you’d  exercise and immediately sell 1,000 ESO shares.

Number of Shares to Cover = “Cost of Exercise” / “Current Share Price”

= $50,000 / $50

= 1,000

Since you sold 1,000 of your ESO to cover the cost, you retain the remaining 4,000. Post cashless exercise, you own 10,000 previously owned shares and 4,000 shares from the exercise and hold, for a total of 14,000 shares

Both the stock swap scenario and the cashless exercise scenario, you retain 14,000 shares. The post-exercise share control is identical.

However, by digging further, you will see that the shares come from different sources.

Long-Only ESO Shares Total Shares Cash Required
Cash Exercise 10,000 5,000 15,000 $50,000
Stock Swap 9,000 5,000 14,000 $0
Cashless Exercise 10,000 4,000 14,000 $0

This difference is important as we evaluate the tax impact if the employee stock options are non-qualified or incentive stock options.

Stock Swap and the Tax Impact for Non-Qualified Stock Options

When you use long-only stock to exercise non-qualified stock options (NQSO) via a stock swap, the swapped shares retain their original cost basis and acquisition date through the exercise.  Swapping shares is a non-taxable event.

However, the exercise itself is a taxable event subject to normal NQSO tax rules. This means that the bargain element of your exercised non-qualified stock options is subject to ordinary income, Medicare, and Social Security tax.

Let’s assume that you have the following NQSOs:

NQSO Exercise Price Exercise Cost Current Share Price Total Value
5,000 $10.00 $50,000 $50.00 $250,000

When you exercise your 5,000 non-qualified stock options, you will pay income tax on the bargain element of $200,000. You pay income tax regardless of how you to pay for the exercise cost of your NQSO.

Assuming you do a stock swap of 1,000 long-only shares that have a cost basis of $20 per share, the cost basis of your retained shares will look like this:

Long-Only NQSO Shares Total
Shares 9,000 5,000 14,000
Cost Basis 9,000 at $20.00/share 1,000 at $20/share

4,000 at $50/share

14,000
Total Cost Basis $180,000 $220,000 $400,000

After the swap, you retain 9,000 long-only shares. The cost basis of these 9,000 shares remains unchanged at $20/share. You have also acquired 5,000 newly owned shares from the exercise of the NQSO.

Of these shares, 1,000 will have a carryover basis (and holding period for calculating long term capital gains) of $20/share. The remaining 4,000 shares will have a cost basis of $50/share, which is the FMV at the time of exercise.

Stock Swaps and the Tax Impact for Incentive Stock Options

You can use long-only stock to exercise incentive stock options, too. Like NQSOs, the tax rules regarding an exercise of incentive stock options, or ISOs, are the same whether you exercise via a stock swap or via another method.

This means that when you exercise and hold ISOs, the bargain element will be a tax preference item for calculating the alternative minimum tax. It also means that exercised ISOs equal to the number of shares swapped will retain thee cost basis of the original shares. However, the newly acquired shares via the exercise will likely have a basis equal to zero.

Continuing our example from above, but now assuming that your have ISOs, we can illustrate a stock swap for ISOs:

ISO Exercise Price Exercise Cost Current Share Price Total Value
5,000 $10.00 $50,000 $50.00 $250,000

If you exercise and hold ISOs in an attempt to achieve a qualifying disposition (hold the shares past year end), you do not claim ordinary income in the year of exercise. Instead, the bargain element is a tax preference item for calculating the AMT.

Since the bargain element not claimed as ordinary income, it has no adjustment to that cost basis of the new shares. If we assume you do a stock swap of 1,000 long-only shares that have a cost basis of $20 per share, the cost basis of your retained ISO shares will look like this:

Long-Only ISO Shares Total
Total Shares 9,000 5,000 14,000
Regular Cost Basis 9,000 at $20.00/share 1,000 at $20/share

4,000 at $0/share

14,000
AMT Cost Basis $180,000 5,000 at $50/share

After the swap, you retain 9,000 long-only shares with a cost basis of $20/share. You also have 1,000 shares from the exercise of the ISO with a carry-over cost basis of $20 per share. These two are the same as what we saw in the example with NQSOs.

The remaining 4,000 shares here, however, have a cost basis of $0/share (which is different than in the NQSO example above).

It’s equally important to track AMT basis. While the cost basis for calculating regular tax is $0/share, the cost basis for calculating AMT is $50/share. This is because the entire bargain element is taxed when calculating the AMT.

Having two basis figures when exercising and holding ISOs is commonly known a dual basis.

Stock Swaps for Other Share Types

The above illustrations cover what a stock swap may look like if you own long-only shares and use those shares for the swap. Typically, long-only shares are shares you purchased on the open market, acquired when your restricted stock units vested, or obtained when you exercised non-qualified stock options.

The shares types above typically have a single cost basis that make them look similar in terms of how they can be used to exercise your employee stock options and what the tax implications may be.

You can also use shares acquired from an employee stock purchase plan or from an exercise and hold of other incentive stock options grants to do a stock swap. However, the rules and taxability of which may become significantly more complicated.

This is because these shares often have different tax rules subject to holding period requirements. These requirements and subsequent tax rules can make using shares received through an ESPP and ISOs in a stock swap more complicated than other methods.

Stock Swap as an Exercise Strategy

A stock swap can be a useful strategy that allows you to do a tax-free swap of shares you own for employee stock option shares. That being said, remember that while the swap is tax free, the exercise itself is not.

When doing a stock swap, you use the FMV of the existing shares to acquire ESO shares at their exercise cost. This typically results in you using some existing shares to acquire more — although your total control of company shares actually goes down.

If you want to limit your position in a stock, a stock swap may be a zero-cash-required way to exercise your ESOs and reduce your overall exposure to a single stock. If you want to maximize your concentrated position, you may want to pass on a stock swap and use cash to exercise your ESOs.

Either way, the experience, objectivity, and accountability a professional can offer may be worthwhile cost if you need help determining whether a stock swap is right for you.

The content herein is for illustrative purposes only and does not attempt to predict actual results of any particular investment.   Diversification does not guarantee a profit or protect against a loss.  None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.  Tax services are not offered through, or supervised by, The Lincoln Investment Companies.

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