Tax-Efficient Stock Option Strategy: Avoid Costly Mistakes

Some parts of this blog were updated on March 14, 2018

Did you hear the one about Melvin? He turned a would-be million-dollar windfall into a $120,000 un-payable tax debt. It would be funny, if it wasn’t so sad — and so very avoidable.

Here’s Melvin’s story: He is a smart guy who works hard at a successful start-up technology company named Flooble. As a reward for his efforts, Melvin is granted 100,000 stock options at $1 per share. When Flooble’s stock hits $15 a share, Melvin exercises his options, generating a $1.4 million paper profit. However, at a 30% tax rate, Melvin’s paper profit also comes with a $420,000 real tax bill. Marvin is confident that Flooble will continue growing briskly, so instead of cashing out, he holds Flooble’s stock for another year. Then the scandal hits. Flooble’s shares plummet to $3 per share. Melvin is left with just $300,000 in stock assets, but he still owes $420,000 to the IRS and is unable to pay. So sad, but Melvin could have dodged this disaster if he had exercised better planning before he exercised his options. (By the way, don’t worry too much about Melvin – he’s fictional. We used him to make a point because this scenario can be very real for those with poor planning.)

Companies who grant stock options typically give employees and other affiliated workers the option to buy company stock at a specified price after a predetermined vesting period. Generally, a percentage of options vest each year over a three-to-five-year period. There are many different agreements and forms of options, each with unique characteristics and tax ramifications. Consulting a tax advisor before you exercise your options is recommended.

Two common forms of stock options are non-statutory options (NSOs) and statutory options, which are also known as incentive stock options (ISOs). NSOs are taxed as ordinary income when they are exercised. The amount subject to ordinary income tax is the difference between the fair-market value at the time of exercise and the exercise price. In Melvin’s case, for example, his exercise price was $1 per share and the stock was selling for a fair-market value of $15, so he made $14 per share – and taxes were due immediately on that gain. If Flooble’s stock had continued to rise, Melvin would have also owed capital gains taxes on any profits above $15 per share, but not until he sold the stock. Because you, like Melvin, will generate a real tax bill when you exercise NSOs, selling all the shares you exercise will avoid risk from the stock depreciating significantly as well as an ill-timed tax liability.

ISOs, which are usually granted to employees, are not taxed at the grant date or the exercise date, but only when the shares are sold. However, if you wish to qualify for favorable tax treatment, you must hold the shares two years from grant and one year from exercise. This is called a “qualified disposition.” If the stock has continued to rise during that period, you’ll only owe long-term capital gains when you sell. However, you may still be required to put up a sizeable amount of cash upon exercise (depending on the strike price). And if you continue to hold onto the shares, the stock’s value could just as easily fall, erasing any gains. (Think Melvin.) There are also some rules to follow or you risk losing some of the advantages ISOs offer. Additionally, you must contend with the potential of triggering the alternative minimum tax (AMT) for the year you exercise these options. These are just some of the reasons you should seek professional advice and put a plan in place before exercising stock options.

In addition to NSOs and ISOs, there are tax rules surrounding Employee Stock Purchase Plans (ESPPs) and Restricted Stock Units/Awards (RSUs/RSAs). These types of equity compensation can have some complications, but may be easier to deal with if you have the right strategy in place. Start by reading our “Tax Guide for the Savvy Investor” and then schedule a free consultation with an advisor today.

Learn more about taxes and how they fit into your holistic financial life by reading our free Personal Capital Tax Guide for Holistic Financial Planning.