Stock Options- When to Exercise

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    First off, thank you for everything…your book “Consider Your Options” is fantastic and has helped me tremendously over multiple reads.

    One thing I’m hoping you can expand on/clarify for me:

    I understand that when you have NQSO that are publicly traded and you want to hold onto the investment, that it’s’s better to hold the option than the stock. in other words, your general recommendation is that you only want to exercise the NSO when you’re ready to sell (to diversify, generate cash etc.) Even with the tax benefits of exercising early and turning some of the gains from compensation income to capital gains….it is typically better to hold the option itself. I get it and agree.

    But does this change for you when it comes to ISO’s? Assuming you’re thinking about holding the stock long term (or at least a few years) would you still rather have the option in your back pocket then exercise and hold the stock. Does the extra tax benefit (that even the discount element would turn into cap gains once held for a year) tilt the scale enough where you would exercise the ISO earlier EVEN IF your plan is to hold that stock for the foreseeable future. You write in the book “exercise the option only when you’re ready to cash out by selling the stock (possibly after a one year holding period if it’s an incentive stock option)or when the option is about to expire.” This makes me think your advice would be the same on the ISO as with the NQO…but just curious. Chapter 18 focuses on does it make sense to hold the ISO for the full year after exercising, but I’m more curious as to your opinion as to exercising the ISO itself when you have no immediate plans to sell.

    Lastly, if the ISO is in a pre-IPO company, (and lets say you’re committed to exercising the options at some point because you believe in the company) would the much larger growth potential (assuming a low strike price) merit exercising as soon as you can? Or would the logic on the NQSO and keeping the option in your back pocket be strengthened?

    Thank you so much!

    Kaye Thomas

    An author is always gratified when someone buys his book, and much more so on the rare occasions when he learns someone has actually read it. But multiple reads? Thats almost scary.

    I was able to be more definitive in my discussion of NQSOs because the situation there is relatively simple. The analysis becomes much more difficult for ISOs, especially pre-IPO.

    Answers depend in part on which of three categories we’re dealing with. In some cases, the bargain element is small enough to fly under the AMT radar, or at least allow us to anticipate full recovery of the AMT credit in the year of sale or shortly thereafter. Some folks have such a large bargain element that the AMT exemption amount, normally a key part of the analysis, becomes an insignificant detail in the planning. Cases that fall between these extremes are the most complicated to plan.

    Pre-IPO situations are more difficult. Shares usually cannot be sold to cover costs of exercising, including any tax cost, or to accomplish ISO balancing (where anticipated AMT credit recovery matches AMT incurred). They also entail greater financial risk, as many a sure thing has turned into a painful reversal.

    So I can’t offer much in the way of rules of thumb here. One strategy to consider is partial exercise each year to the level where AMT begins to apply, to maximize use of the AMT exemption amount. I don’t think my book says much about this idea because it was written at a time when few taxpayers could gain any significant benefit. Recent changes in AMT and other tax rules may make it worth considering.

    Beyond that, you need to sharpen your pencil, or rather, your spreadsheet skills, and try some scenarios, always bearing in mind investment risk and the dismaying frequency with which the tax laws change.

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