Is Exercising Incentive Stock Options Your Best Strategy?

Wouldn’t it be great if your company stock price only ever went up—especially if you’re participating in its growth through incentive stock options (ISOs)? Unfortunately, that’s not always how the world turns. If the share price goes down instead, you may be bummed to see the value of your incentive stock options is less than what it once was.

However, a down stock price might mean that you could score some tax breaks if you exercise and hold some of those ISOs. When the price is down, the move might help minimize alternative minimum tax (AMT).

If this strategy were your only recipe for turning low-priced lemons into lemonade, it may hold some water. However, in today’s post, I’m going to propose another, potentially even sweeter possibility to consider when the stock price is down: What if you left the ISOs unexercised, and instead bought additional shares outright, using the cash you would have allocated to exercise and hold your ISOs?

Intriguing idea, isn’t it? Or maybe it’s just confusing at this point. Today, let’s unpack what I’m talking about. But first, some higher-level comments.

How Do You Really Feel About Your Company Stock?

Empirically, we will show you why you may not want to exercise your ISOs as the fair market value (FMV) drops down near the strike price. Instead, if you’re a believer in the long-term prospects of the stock, you may be better off buying additional shares of long stock. Controlling additional shares bought outright, coupled with a disqualified ISO sale, may result in a higher after-tax value.

However, in the grander scheme, does it really make sense to buy additional shares of company stock, particularly if you are already holding a concentrated position? Is this something you would be comfortable with? Does it make sense for your total investment portfolio?

If the math suggests buying additional shares is the best bet, it may seem like a no-brainer to do so. However, if your gut, and/or your investment plans don’t call for buying additional employee stock shares, maybe you shouldn’t. For that matter, should you be injecting money into exercising and holding any ISO shares either?

There is no perfect answer. My sense is today’s exercise might be appropriate for those who are optimistic about their company stock; can afford the cash flow to purchase more shares; and are willing and able to assume additional concentrated investment risk.

Clearly, personalized financial planning is a must before you proceed one way or another. The analysis should lead to an interesting dialogue: What is your risk tolerance? How do you feel about the company and its stock price? Are you aware of how often employees’ myopic perspectives can lead them astray? (Think Enron, etc.)

In that context, let’s look at the possibilities for managing incentive stock options when the price is down.

Leaning Into the Losses

When a price drop leads to a smaller spread between the FMV of the stock and the ISO exercise price, there’s a smaller bargain element and a smaller adjustment for figuring the AMT. A smaller spread between the two prices may occur if you are at an early stage or pre-IPO company with a lower 409(a). It may also occur if you are at a public company whose stock price has dropped from its previous high.

Either way, if you are seeking to minimize or mitigate AMT when you exercise and hold your ISOs, you may want to do so when the spread is small between the strike price and the prevailing fair market value (FMV). In this context, smaller is “better” than bigger. How much better? Essentially, it depends on how closely the stock’s FMV tracks the option’s exercise price. Bear that in mind as we walk through the numbers and theories involved.

A Review of Qualifying and Disqualifying Dispositions of Incentive Stock Options

First, a bit of review. Remember, to make a qualifying disposition, the final stock sale must occur:

1. At least 2 years past the ISO grant date, AND
2. At least 1 year past your exercise date

If you meet these hurdles, gain on the stock sale from the strike price of the ISO and the final sale price is taxed at favorable long-term capital gains rates. In 2022, these rate tiers were 0%, 15%, and 20% (not including potential net investment income tax). However, there are two caveats to these favorable rates:

1. Stock risk: To meet the standard for a qualifying disposition, you take on stock risk during the required one-year, post-exercise hold. During this time, the stock can move up or down. While everyone hopes their stock price will go up, a down market post-exercise could leave you wishing you had exercised and sold your stock immediately.
2. AMT: You may owe AMT in the years you exercise and hold ISOs.

A disqualifying disposition of ISOs is anything that does not meet both requirements for a qualifying sale as noted above. If you exercise and sell your incentive stock options as a disqualifying disposition, a portion of your profit may be taxed as ordinary income (potentially all of it, if you initiate a cashless exercise and sell), and a portion may be taxed as a capital asset, subject to short- and long-term capital gains rates.

There are seven ordinary income tax rates in 2022, including 10%, 12%, 22%, 24%, 32%, 35%, and 37%. Depending on your other income for the year, and the size of your ISO exercise and sell, some of your profit may be taxed at any or all of these rates.

Scenario A: A Qualified, Exercise and Sale of Incentive Stock Options

To kick off our empirical analyses, let’s illustrate, what it might look like to exercise your ISOs upfront, when the share price is relatively low, and making a qualified disposition more than a year later, and once the price has increased. For simplicity, we will exclude AMT from this analysis. (If you’d like to learn more about AMT and its impact on ISO, you can read here, here, and here.)

• Incentive Stock Option: 2,000
• Strike (Exercise) Price: $5.00/share
• Current FMV: $25.00/share
• Future FMV: $50.00/share
• Long-Term Capital Gains Rate: 20%
• Ordinary Income Tax Rate: 37%

The first step is to exercise your ISOs. At exercise, you will purchase 2,000 shares of stock at your $5 per share option price (even though the current market value is $25 per share), for a total cost of $10,000. (A reminder that we are excluding AMT from our analysis at this point.)

Second, assuming a qualified sale, we can calculate the final after-tax proceeds using the following formula, applying the 20% capital gains rate:

After-Tax Value = [Number of ISO x (Future FMV – Strike Price)] x (1 – Tax Rate)

= [2,000 x ($50 – $5)] x (1 – .20)

= $90,000 x .80

= $72,000

In this example, the after-tax value of your exercise and qualified sale is $72,000.

Scenario B: A Postponed Disqualified Exercise and Sale of Incentive Stock Options

Continuing our hypothetical examples, let’s assume you do not exercise your incentive stock options when the FMV is $25 per share. Instead, you keep your unexercised ISOs until the share price reaches $50/share. Then you complete an exercise and sell cashless transaction, with the taxable proceeds taxed as ordinary income.

Following the same formula, we’ll adjust the tax rate to the disqualifying disposition higher ordinary income rate:

After-Tax Value = [Number of ISO x (FMV – Strike Price)] x (1 – Tax Rate)

= [2,000 x ($50 – $5)] x (1 – .37)

= $90,000 x .67

= $56,700

In this example, the after-tax value of your disqualified sale is $56,700. In comparison, Scenario A’s ISO exercise and hold with a qualifying disposition generated approximately 27% more wealth.

Scenario C: Purchasing Additional Stock Shares in Lieu of Exercising and Holding ISOs

Now, finally, let’s get to the meat of this post. What if you forgo exercising your incentive stock options when the FMV is on the low side, and you instead lean into the loss by purchasing more shares?

So far, we’ve compared two concepts on either side of the spectrum. In Scenario A, we illustrated an exercise and hold of all incentive stock options, followed by a subsequent qualified sale. In Scenario B, we illustrated a disqualified exercise and sale of all incentive stock options. Of course, these two scenarios don’t exhaust all possibilities by a long shot, but they give us reasonable reference points from which to continue.

So, next, using our existing assumptions, let’s explore the impact of NOT exercising your ISOs (as we did in Scenario A), but also NOT just waiting and doing nothing until the share price has increased (as in Scenario B).

What if, instead of exercising and holding your ISOs at $25 per share, you used that same $10,000 acquisition cost to buy additional long shares of stock? Then, at $50 per share, you exercise and sell your ISOs as a disqualified sale (as in Scenario B), PLUS you sell your long shares at a long-term capital gain, like so:

• ISOs Unexercised: 2,000
• Additional Long Shares Purchased: 400
• Final Sale Price: $50.00

When the shares are sold, the tax calculations are as follows:

	Options/Shares	Strike	Cost	FMV	Sale Price	Proceeds	Taxable Gain	LTCG Tax (20%)	Ordinary Income Tax (37%)	After-Tax
Option	2,000	$5.00	$10,000	$25.00	$50.00	$100,000	$90,000		($33,300)	$56,700
Shares	400		$10,000	$25.00	$50.00	$20,000	$10,000	($2,000)		$8,000
										$64,700

 

As you can see, in this example, the total after-tax proceeds is $64,700. That’s better than Scenario B, in which we did nothing when the share price was low, but it’s not the preferred outcome compared to the Scenario A exercise and hold action, with a total after-tax qualified disposition value of $72,000.

However, this does not mean there’s never any merit to buying additional shares when the price is right. Next, let’s expand on Scenario C by examining various strike prices, FMVs at exercise (and at purchase of additional shares), and final sales prices. If we do, we’ll discover there are times when buying additional shares outright “wins,” even with a disqualified disposition.

Additional Scenarios: When Buying Additional Shares “Wins”

Illustrating the concept, let’s assume, instead of $25 per share FMV at exercise (and purchase of additional shares of stock), it is now only $15 per share. Following the same after-tax calculations as above, and comparing a qualified sale of ISO vs. a disqualifying sale of ISO + purchase of additional stock, we can figure the following:

1. Exercise and Hold for Long-Term Capital Gains: Here, the ISOs are exercised and held, sold as a qualified sale subject to long-term capital gains rates, and generate net after-tax proceeds of $72,000. (You may notice this is the same outcome we reached in Scenario A, since the strike and sale price for calculating taxable gains are the same in both.)

	Options/Shares	Strike	Cost	FMV	Sale Price	Proceeds	Taxable Gain	LTCG Tax	Ordinary Income Tax	After-Tax
Option	2,000	$5.00	$10,000	$15.00	$50.00	$100,000	$90,000	($18,000)		$72,000

 

2. Using Cash to Buy Additional Shares/Sell ISO as Disqualified Sale: Next, we purchase 667 long shares (rounded up), for a total cost of $10,005. (Because the acquisition cost is now $15 vs. $25 per share as in our original example, it’s possible to control 267 additional shares.) At final sale, the proceeds of the disqualified ISO sale remain unchanged, and are taxed as ordinary income. However, the after-tax proceeds from the additional shares increase, as more shares are controlled and a greater portion is taxed at long-term capital gains rates. In this example, the taxable gain is $23,333 for a tax due of $4,667. This yields after-tax proceeds of $75,367, or $3,367 higher than the first, qualified sale only.

	Options/Shares	Strike	Cost	FMV	Sale Price	Proceeds	Taxable Gain	LTCG Tax	Ordinary Income Tax	After-Tax
Option	2,000	$5.00	$10,000	$15.00	$50.00	$100,000	$90,000		($33,300)	$56,700
Shares	667		$10,005	$15.00	$50.00	$33,333	$23,333	($4,667)		$18,667
										$75,367

 

3. Discovering the Breakeven Point: Taking this one step further, we can calculate the breakeven point, at which both actions yield the same $72,000 after-tax proceeds. For that, the exercise price needs to be $17.17 (rounded), enabling you to purchase and hold approximately 582 additional long shares.

	Options/Shares	Strike	Cost	FMV	Sale Price	Proceeds	Taxable Gain	LTCG Tax	Ordinary Tax	After-Tax
Option	2,000	$5.00	10,000	$17.1675	$50.00	100,000	90,000	(18,000)		72,000

 

	Options/Shares	Strike	Cost	FMV	Sale Price	Proceeds	Taxable Gain	LTCG Tax	Ordinary Tax	After-Tax
Option	2,000	$5.00	$10,000	$17.17	$50.00	$100,000	$90,000		($33,300)	$56,700
Shares	582.4959953		$10,000	$17.17	$50.00	$29,125	$19,125	($3,825)		$15,300
										$72,000

A Note on the Alternative Minimum Tax

Again, for this illustration, we intentionally removed AMT from the equation by assuming you can credit into the future any AMT paid in the year of exercise and hold on a qualified sale. That would make it a zero-sum event. However, AMT may be due, and complicate our simplified scenarios. Of course, it may also impact overall cash flow and affordability of an exercise and hold.

On that note, let’s wrap by describing the theory behind all the numbers just presented.

Exercising ISOs vs. Buying More Stock Shares When the Price Is Down

With our series of scenarios, we’ve now essentially illustrated the following:

All else being equal, the closer your company stock’s FMV drops toward your ISO strike price, the more advantageous it may be to purchase additional shares instead of choosing to exercise and hold your ISOs.

There are several reasons for this.

• As the FMV approaches your strike price, you can purchase a greater number of long shares as a percentage of the total unexercised ISOs you hold.
• More long shares mean you are able to capture more of the same long-term tax benefit you would receive from exercising and holding the ISO themselves, even as you continue to control a greater percentage of the stock with the combination of unexercised ISO and long shares.
• You also benefit by retaining leverage of the ISOs that remain unexercised.

It’s also worth mentioning: We used the highest 20% capital gains rate and 37% ordinary income tax rates. If the gains rate were even lower, the benefits of buying additional long shares becomes even better.

Last but not least, we’ll close with the caveat we opened with, as it bears repeating: Seeking optimal tax treatment isn’t without its tradeoffs. Whether you decide to buy additional shares, exercise and hold ISOs, or both, don’t forget you’re also taking on concentrated stock risks moving forward. If the share price/FMV continue to drop, you may lose more than the tax savings are worth.

Is it worth it to lean into a declining company stock by buying more shares? That’s between you and your financial planner.

This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.