Strategies for incentive stock options are complicated by the need to factor in the effect of the alternative minimum tax (AMT). In my writings on managing stock options — Consider Your Options, a book for option holders, and Equity Compensation Strategies, a text for professional advisors — I explain why the optimal approach from a tax perspective for people who have very large profits built into their ISOs is to sell 65% of the shares immediately after exercise of the option and hold 35% long enough to convert the profit on those shares to long-term capital gain. The “35% solution” changes when tax rates change. This is the first of two articles on how these changes affect ISO strategy for options exercised this year, given that shares not sold immediately will be taxed at next year’s capital gains rates, and for options exercised in later years, when both regular tax rates and capital gains rates will be higher.
Finanacial Advisor magazine published an article quoting us on this subject and referring to this series of articles.
We begin with an explanation of the 35% solution as it applied to option exercises before 2010. The underlying premise is that the profit from shares sold in a disqualifying disposition is taxed at 35% under the regular income tax, the AMT rate on shares that are not sold in the year of exercise is 28%, and the capital gains rate on shares sold the following year is 15%. These are not necessarily true in all situations, but typically provide a good approximation where the amount of profit built into the ISO is large. We’re also assuming that there’s nothing unusual about your AMT situation prior to dealing with the options. For convenience we’ll assume an option profit of $100,000, although this number would not be large enough to produce the tax rates just described in all situations. We’re also going to assume you have the same amount of profit regardless of whether you sell the shares immediately or hold them for a year (in other words, the stock value remains unchanged during the holding period).
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To understand the 35% solution, let’s first look at what happens if you exercise and hold all the shares. In the year of exercise you report no income for purposes of the regular income tax but have a $100,000 “adjustment” for AMT purposes, so you pay AMT in the amount of $28,000. The following year you sell the shares, cashing in the $100,000 profit. For regular tax purposes this is a $100,000 long-term capital gain taxed at 15% for a tax of $15,000. Under the AMT this profit was taxed in the previous year so it is excluded from AMT when you sell the shares. That means you’ll recover $15,000 of AMT credit, completely offsetting the regular income tax on the sale. Your overall tax cost is $28,000 (all paid in the first year, with zero additional tax in the second year). You also have $13,000 of unused AMT credit, but this may turn out to be of little or no value.
You can achieve exactly the same tax result (except for the AMT credit carryover) while holding fewer shares. The minimum number of shares to get this result is 35% of the total. Here’s how that would work.
Immediately after exercising the option you sell enough shares to cash in $65,000 of your profit. This amount is taxed as ordinary income under the regular income tax, producing a tax (at 35%) of $22,750. You also owe AMT in the year of exercise, because the entire $100,000 of profit (relating to both the shares sold and the shares held) is included in your AMT income. That boosts your tax under the AMT rules by $28,000, and after we subtract the $22,750 you’re paying under the regular income tax we find that you owe $5,250 in AMT. Your total tax this year is $28,000, the same as if you had held all the shares, but now it’s divided between regular income tax and AMT. The following year you cash in the remaining $35,000 of profit, incurring a capital gains tax of $5,250, which is neatly offset by full use of the AMT credit.
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The 35% solution doesn’t permit you to pay any less tax than the strategy of holding all your shares after exercising the option. But it doesn’t require you to pay any more tax, unless you count potential (and often speculative) tax savings from utilizing the AMT credit carryover. The key is that it exposes you to holding period risk as to only 35% of the shares instead of 100%. It also eliminates the risk that you won’t have cash available to pay the tax liability associated with exercise of the option, because you’re cashing in enough profit immediately so that you can either pay the tax up front or set cash aside to pay it later.
In short, this is potentially a highly advantageous approach for many holders of incentive stock options. The math changes, though, when income tax rates change. Part II of this series will explain how this strategy is affected for options exercised in 2010 and later years, given that higher tax rates are anticipated in 2011.
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