Changing Tax Rates Affect ISO Strategy — Part II

June 8, 2010

In a previous post we explain why, for years prior to 2010, it was potentially advantageous for individuals holding incentive stock options with large built-in profits to adopt a strategy under which they sell 65% of the shares immediately after exercising the option and hold 35% of the shares long enough to avoid a disqualifying disposition. In this post we explain how the “35% solution” changes for options exercised in 2010, and changes again for options exercised in 2011.

The 35% solution is based in part on the assumption that a 15% capital gains tax rate will apply to shares sold after the ISO holding period has been satisfied. This assumption isn’t valid for options exercised in 2010 because it is widely expected that the top capital gains rate will revert to 20% in 2011. Major tax legislation affecting years after 2010 has yet to take shape, but a 20% capital gains rate appears highly likely.

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Let’s rework the example from our previous post with this in mind. In 2010 you exercise an ISO with $100,000 of profit built in and immediately sell enough shares to cash in 65% of your profit. You pay total tax of $28,000 for 2010, consisting of $22,750 in regular income tax and $5,250 in AMT. Here’s where things are different: when you sell the remaining shares in 2011, your capital gains tax on the $35,000 profit is $7,000 at the 20% rate, not $5,250 as it would be at the 15% rate. This $35,000 profit is not taxed under the AMT, but your AMT credit isn’t large enough to fully offset your regular income tax on this profit because you paid only $5,250 of AMT in the year you exercised the option. As a result, you end up paying an additional $1,750 in income tax the second year ($7,000 minus the AMT credit).

If you want to optimize the tax result for options exercised in 2010 you need to hold a larger fraction of the shares. Instead of cashing in 65% of your profit immediately, you would cash in only 53.3%. When you cash in the remaining profit in 2011, your AMT credit will be large enough to fully offset the regular income tax on this profit.

For options exercised in 2011 or later the math changes again. The optimal percentage actually depends on three tax figures: the regular income tax rate, the AMT tax rate, and the capital gains rate. It appears likely that the top rate under the regular income tax will rise to 39.6% next year, and if so, we can no longer use 35% in the calculation. Rounding just a bit (treating the top regular rate as 40%) we find that you need to hold a still larger number of shares to secure the maximum tax benefit, cashing in only 40% at the time of exercise while holding the remaining 60%.

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I should exmphasize that many simplifying assumptions go into this tax calculation. We haven’t taken into account state income tax, for example, and we’ve assumed away any adjustments that might apply due to phasing out of the AMT exemption amount or the possibility that you are already in the AMT prior to exercising any options. We’ve also ignored the possibility of absorbing a greater tax benefit from your ISO by exercising in a year when you have another large source of income, such as from exercising nonqualified stock options, or for that matter, from a Roth conversion.

I should emphasize as well that a truly optimal strategy must take into account the risk of holding shares following exercise of the option. You shouldn’t feel obligated to adopt a strategy that minimizes tax while exposing yourself (and anyone who depends on you for support) to excessive investment risk. In short, the figures discussed here are merely one step in formulating a stock option strategy that makes sense for your individual situation.