This guide isn't intended to provide a definitive answer, as many factors unique to each situation prevent a one-size-fits-all solution. However, it should help you identify key considerations for making this decision. These topics form the basis of discussions with my clients, assisting them in creating a tailored plan for exercising and selling their Incentive Stock Options (ISOs).

Check out our stock compensation wiki for more information.

What are ISOs?

A stock option is a form of equity compensation, enabling employees and in some cases service providers to purchase company shares. However, stock options are not actual shares. They offer the right to buy a fixed number of shares at a predetermined price, known as a strike or exercise price. If the stock value increases, you could profit from the difference, which may be taxable.

There are two kinds of employee stock options: incentive stock options (ISOs) and non-qualified stock options (NSOs). Both offer partial company ownership, differing mainly in their taxation—ISOs may qualify for tax benefits.

Companies may also offer other equity awards like restricted stock awards (RSAs) or restricted stock units (RSUs), which differ from stock options and have unique tax implications.

What are the decision factors that will influence the exercise of your incentive stock options?

1. When to Exercise: Consider the timing of exercising the ISOs. The decision may depend on market conditions, the stock's performance, personal financial circumstances, QSBS status, and tax implications.

2. Holding Period: To qualify for long-term capital gains tax, which is usually lower than ordinary income tax, the client must hold the stock for at least one year after exercise and two years after the grant date. This requirement needs careful consideration.

3. Risk Tolerance: Evaluate the risk of holding a significant portion of wealth in a single company's stock, which can be risky if the company's fortunes change.

4. Tax Implications: ISOs can trigger the Alternative Minimum Tax (AMT) if the spread at exercise is substantial. Engaging a tax professional to calculate potential AMT liability is advisable (Feel free to schedule a call to discuss your situation)

5. Exercise Strategy: Consider whether to exercise all options at once or to spread the exercise over several years to manage tax implications.

6. Future Plans: Keep an eye on future income and capital gains, which could push the client into a higher tax bracket or trigger AMT.

7. Financial Planning: The exercise of ISOs and the sale of the resulting stock should be part of a comprehensive financial plan that takes into account the client's overall financial goals, other investments, risk tolerance, and retirement plans.

Remember, all these decisions should be made in consultation with a financial advisor, tax professional, or attorney as they have complex financial and tax implications.

How are employee stock options taxed?

Stock options are usually taxed at two stages:

1. When they're exercised (bought)

2. When they're sold.

ISOs and NSOs differ as follows:

• ISO: The exercise may be subject to the alternative minimum tax (AMT), and the sale can result in ordinary income or capital gains tax.

• NSO: The exercise might attract ordinary income tax, and the sale will lead to capital gains tax (short or long-term).

Let’s focus on ISOs…

Below is a guide that will help you understand how ISOs are taxed:

When should you exercise your ISOs?

Example:

You joined a startup 1/1/2021 and you were offered 100,000 ISOs under a standard four-year time-based vesting schedule with a one-year cliff, 1/4 of your shares vest after one year. After the cliff, 1/36 of the remaining granted shares (or 1/48 of the original grant) vest each month until the four-year vesting period is over. After four years, you are fully vested.

1st Decision Point

Assuming the startup allows for early exercise, then you have to decide whether or not you want to exercise early? Are you optimistic about the company?

Pros of Early Exercise:

1. Lower Taxes: You can minimize your tax liability if the spread between the exercise price and the 409A fair market value (which is subject to AMT for ISOs) is zero.

2. Starting the Long-term Capital Gain Clock: If you believe the company will be successful, exercising early starts the clock for long-term capital gains earlier. This means you can qualify for lower capital gains tax rates sooner.

Cons of Early Exercise:

1. Risk of Losing Investment: The startup might not succeed. If you pay the exercise price early and the company fails, you lose your investment.

2. Liquidity: The cash spent on the early exercise is tied up in the stock, which may not be sellable until a liquidity event occurs (like an IPO or acquisition). This could tie up your capital for an extended period.

2nd Decision Point

On 1/1/2022, 25,000 shares are vested.

Do you hold the stock for long-term capital gains or not?

Pros of Holding for Long-term Capital Gains:

1. Lower Tax Rate: If you hold the stock for at least one year from the exercise date and two years from the grant date, any gain is taxed at the long-term capital gains rate, which is generally lower than the ordinary income tax rate.

2. Potential for Higher Gains: If you believe the company's value will significantly increase, holding the stock could result in more substantial capital gains.

Cons of Holding for Long-term Capital Gains:

1. Market Risk: The company's stock price may decline during the holding period, reducing the value of your investment.

2. Liquidity Risk: You can't sell the shares during the holding period if you need cash (such as paying for taxes), except at the risk of losing the long-term capital gains tax advantage.

What do most people do?

Potential Alternative Strategy

Consider a staggered exercise and sale strategy. Rather than exercising all vested options at once, you could exercise a portion of your vested options each year, diversifying your tax liability over several years and potentially minimizing AMT implications. Also, by not selling all your shares at once, you can potentially take advantage of future stock price increases while reducing risk. As always, discuss these strategies with a tax professional or financial advisor to understand all potential implications.