You’re planning to exercise your incentive stock options (ISOs) soon, and you’d like to do so in the most tax-efficient way.
In the final months of the year, it can be tempting to wait to exercise until January, on the belief that you won’t owe taxes on the transaction until the following April — giving yourself 15 months to figure out how to pay for your tax bill.
We commonly hear from clients that they’re planning to exercise stock options at the start of the year, and wait at least 12 months before selling, to also take advantage of long-term capital gains before the following tax season.
Both ideas hinge on a common misconception — that waiting until a new calendar year to exercise and/or sell your stock means that you can push your stock options-related tax liability into the following calendar year.
The good news is that exercising your stock options now might very well reduce your overall tax liability. Let’s unpack this topic a bit more.
Exercise stock options now to reduce your overall alternative minimum tax (AMT) bill
Let’s say you work for a pre-IPO startup, and have 20,000 ISOs that you’d like to exercise in the near future.
Depending on your financial situation, splitting up this exercise over two calendar years might result in lower upfront taxes, by taking advantage of something called the “AMT threshold.”
For example, exercising 10,000 ISOs in December, and 10,000 ISOs in January would mean you’d split up your alternative minimum tax liability across two calendar years. In some cases, doing so could mean that you avoid paying AMT altogether.
In this example, if you were to instead exercise all 20,000 ISOs in January, you run a greater risk of a high upfront AMT bill, because your stock options-related tax liability would be concentrated in a single calendar year.
Unlike income, stock options are taxed immediately
When you exercise (i.e. purchase) your stock options, you immediately trigger a taxable event, and you’ll need to report the details about your exercise to the IRS. While non-qualified stock options (NSOs) are treated like income (meaning companies typically set aside taxes owed) that’s not the case with ISOs.
With ISOs, you’ll need to report (and pay) those taxes yourself. That could make it likely that you’ll need to pay quarterly estimated payments, instead of waiting until the following year. So, for example, if you were to exercise stock options in January, the IRS would expect you to pay any associated taxes in the first quarter of that year.
If you wait to pay your stock options-related taxes until the following year, you could face a penalty from the IRS. Of course, you should always consult with a CPA or certified financial advisor when making a decision about taxes.
Waiting means it could get more expensive to exercise your stock options
Pre-IPO startups that offer stock options regularly perform 409A valuations (also known as fair market value valuations), where they bring in an outside firm to estimate the current value of the startup’s stock.
For people working at fast-growing startups, waiting to exercise means you run the risk that your startup updates its 409A valuation in the meantime, and you end up owing more upfront taxes than you originally expected. That’s because the taxes you owe are based on the difference between your strike price and the 409A. So as your company’s valuation climbs, so too does your overall cost to exercise.
Many companies update their 409A at the start of every calendar year, and again if an event occurs that meaningfully changes the value of the company, such as a new funding round.
Exercising now starts the clock on long-term capital gains
For people who want to exercise their stock options, there can be significant tax savings by exercising early enough to take advantage of long-term capital gains.
This benefit is arguably negligible if you’re planning to exercise a portion of your ISOs in December, and immediately again in January. That said, it’s impossible to predict the future — your startup could be acquired in the next 12 months, and starting the clock now on long-term capital gains could result in tax savings upon exit.
If you’re building a plan for your stock options and want to maximize your tax savings, check out Secfi’s Stock Option Tax Calculator.