First time dealing with ISOs, unsure what to do

Have a question about your personal investments? No matter how simple or complex, you can ask it here.
Post Reply
Topic Author
younginvestor44
Posts: 15
Joined: Wed Jan 06, 2016 2:49 pm

First time dealing with ISOs, unsure what to do

Post by younginvestor44 »

Hi everyone,

The company I work for recently went public and I have vested ISOs which I did not exercise pre-IPO. I've done a lot of research on ISOs, and I had a bit of a hard time wrapping my head around AMT implications initially. However, after doing quite a bit of reading, I have a good understanding now. In summary, it seems like I should have exercised these ISOs earlier when the FMV was lower to minimize the AMT impact. However, this would have come with some risk as well (e.g. if the company never ended up going public). Either way, can't change the past. Breakdown of various strike prices below:
  • 5000 at $0.40 strike price
  • 1500 at $2.00 strike price
  • 500 at $7.00 strike price
The stock is trading at around $40 a share now. Other than this event, I have a fairly standard tax situation. Single, late 20s, no kids, standard deduction, etc.. My gross income is around $200k, taxable income is around $168k. Current NW (not including the value of ISOs) is $550k, exclusively in index funds (95% stocks/5% bonds). As I understand things, below are my options:

Option 1: Exercise just enough of the options this year to stay below the AMT threshold. Based on my calculations and my income, it seems like this will be a pretty low amount, somewhere in the ball park of 800 options at the $0.40 strike price. Then continue to do this every year, ideally at the beginning of the year in Jan/Feb. In this scenario, I would hold the stock.

Option 2: Exercise everything now, and take the AMT hit, which based on some rough calculations would be around $75k. I would then have an AMT credit for subsequent years, but this basically seems like an interest-free loan to the IRS. Also, there's the risk that the stock tanks after I exercise and I am still left with a large AMT bill. In this scenario, I would hold the stock.

Option 3: Exercise everything now, and sell in the same year to avoid AMT. I would have to pay short term capital gains, and would miss out on any potential upside.

Option 4: Don't exercise anything now, keep an eye on price of stock, and exercise once it is at a price I'm satisfied with. Sell in the same year to avoid AMT, but incur short term capital gains and miss out on further upside.

Are there any other options that I am missing? For others who have been through an IPO and have dealt with ISOs, any advice or recommendations Thanks!
kxl19
Posts: 154
Joined: Wed Mar 13, 2013 12:41 am

Re: First time dealing with ISOs, unsure what to do

Post by kxl19 »

I've been thru a similar experience. I've recommended to friends who know that their company is about to IPO (companies usually tell their employees before the IPO date), and if they're OK with the risk, it makes sense to exercise some (if not all) the ISO pre-IPO (ie, during the roadshow period), because there's generally a big gap-up between the private and public traded price. (ie, the liquidity premium).

When deciding between exercising and hold vs exercise and sell immediately your ISOs, make sure to consider your tax bracket.

If in a low bracket, the income tax of exercise/sell vs. LTCG are similar, so I'd lean towards exercise + immediate sell

If in a high bracket, and you're tolerant of risk, you could exercise+Hold to get LTCG. Granted, AMT may be an issue, so you could exercise just up to the AMT threshold. The risk is the stock price could drop after your exercise. However, the advantage of exercise+hold is that there could be a huge tax savings.

Eg - if in high bracket: exercise + sell = income-level tax, so 37% fed + state tax
If exercise + hold for LTCG, pay 23.8% LTCG + state tax.
oopsmybad
Posts: 1
Joined: Sun Jul 18, 2021 8:14 pm

Re: First time dealing with ISOs, unsure what to do

Post by oopsmybad »

My experience was somewhat of an extreme case. I believed whole-heartedly in the company I worked for, had a buy-and-hold mentality, and believed in investing for the long run. I exercised my ISOs, paid the AMT, and then held them for a couple years. Eventually my company was bought out, by another company that had a lot of debt. Even though business was booming, we were hiring, etc., the decision makers saw an opportunity to strategically default - essentially reorganize in bankruptcy. Very abruptly, unexpectedly, and quite spectacularly, our stock price went from the sixties to the pennies, and then subsequently all the way to zero.

I was left with an almost unbelievable AMT credit. The stock I expected to sell and pay long term capital gains on no longer existed, so the AMT credit wasn't much use, except to offset my regular income taxes. It would have taken at least two decades, probably longer, for me to use that enormous AMT credit... but, an improbable, perhaps even miraculous bit of congressional lobbying made the "dot-com collapse" AMT credit refundable over a period of five years, and so uncle Sam paid us back in a reasonable amount of time. That said, I believe the refundability of the AMT credit was a one-time program. If you walk onto the AMT tight-rope today, I don't think there's a net to catch your fall.

Obviously mine was an extreme case, and is unlikely to happen to you - at least, not in that exact same way. That said, I would humbly give you some food for thought.

Not surprisingly, I believe that playing with AMT is akin to messing with fire. When channeled via a rocket, fire can get you into outer space! It can also burn your house down and destroy everything you own. I wouldn't take that risk again.

However, I unequivocally believe that diversifying through the controlled divestiture of ISOs/company stock is very very important. I was literally a teenager when I was given my ISOs. A very wise (and much much older) product manager that I worked with tried, tried, and tried to sell me on the notion that having so many eggs in one basket was a bad idea. I didn't listen. I said "this is the new economy, all the old rules are dead, this time it's different", etc... He ended up with an amazing condo with a view of the SF bay, and I kept living in rent controlled apartment in SJ.

Much like you would dollar cost average into the stock market, I would always be exercising/immediately selling a block of ISOs, every 6 months, paying short-term capital gains taxes and reinvesting what's left into your broadly diversified index fund portfolio. If you plan to stay with your company over the longer term, you can exercise/sell your ISOs in a similar manner as your original vesting schedule. For me, I vested 25% every 4 years, so if I could do it again, I'd exercise and sell 25% of all my vested ISOs each year. Really it could be anything you're comfortable with. (Note that if you intend to leave the company in the near future, the "what do I do with the ISOs" becomes a very complex issue.)

You probably live in a HCOL state and pay lots of taxes, and it sucks handing over such a huge chunk of cash to the government. But... look at it this way. If you exercise and sell immediately, you pay short term capital gains, obviously.... but, you know the dollar amount difference between the STCG and the LTCG rate? The money you lose using that strategy? Well, that dollar amount actually buys you: 1) insurance against the evil destruction that could result from the AMT, and 2) the ability to immediately diversify into another investment that doesn't carry the same concentration risk as your company stock holdings. If I could go back and do everything again, I would pay that extra cost with a smile on my face every single day.

All that said - these are my opinions, based on my sole experience. I would encourage you to listen and consider all the advice your given, especially from anyone who says I'm full of crap. :happy

One last thing. If you ever do decide to exercise, pay AMT and hold for 365+ days.... I recommend you immediately sell (right after the exercise) enough stock to pay for: the cost of exercising the options, the AMT bill on what you'll hold, and short term capital gains taxes on the stock you're selling (to pay for all 3 of these). If you do this, you make the stock you exercise pay for itself, at the very least. If you don't, there's a scenario where you use your cash/savings to exercise the options, sell nothing, and then watch the value of the stock drop below the total dollar amount of AMT you'll owe. Even if the stock price rises again post-AMT, digging into your cash/savings to pay taxes on an asset that's worth less than the tax bill would really suck. Trust me on that one.

Oh, and congrats on your IPO!
Topic Author
younginvestor44
Posts: 15
Joined: Wed Jan 06, 2016 2:49 pm

Re: First time dealing with ISOs, unsure what to do

Post by younginvestor44 »

kxl19 wrote: Sat Jul 17, 2021 9:47 pm I've been thru a similar experience. I've recommended to friends who know that their company is about to IPO (companies usually tell their employees before the IPO date), and if they're OK with the risk, it makes sense to exercise some (if not all) the ISO pre-IPO (ie, during the roadshow period), because there's generally a big gap-up between the private and public traded price. (ie, the liquidity premium).

When deciding between exercising and hold vs exercise and sell immediately your ISOs, make sure to consider your tax bracket.

If in a low bracket, the income tax of exercise/sell vs. LTCG are similar, so I'd lean towards exercise + immediate sell

If in a high bracket, and you're tolerant of risk, you could exercise+Hold to get LTCG. Granted, AMT may be an issue, so you could exercise just up to the AMT threshold. The risk is the stock price could drop after your exercise. However, the advantage of exercise+hold is that there could be a huge tax savings.

Eg - if in high bracket: exercise + sell = income-level tax, so 37% fed + state tax
If exercise + hold for LTCG, pay 23.8% LTCG + state tax.
This is super helpful, thank you
kxl19 wrote: Sat Jul 17, 2021 9:47 pm I've been thru a similar experience. I've recommended to friends who know that their company is about to IPO (companies usually tell their employees before the IPO date), and if they're OK with the risk, it makes sense to exercise some (if not all) the ISO pre-IPO (ie, during the roadshow period), because there's generally a big gap-up between the private and public traded price. (ie, the liquidity premium).

When deciding between exercising and hold vs exercise and sell immediately your ISOs, make sure to consider your tax bracket.

If in a low bracket, the income tax of exercise/sell vs. LTCG are similar, so I'd lean towards exercise + immediate sell

If in a high bracket, and you're tolerant of risk, you could exercise+Hold to get LTCG. Granted, AMT may be an issue, so you could exercise just up to the AMT threshold. The risk is the stock price could drop after your exercise. However, the advantage of exercise+hold is that there could be a huge tax savings.

Eg - if in high bracket: exercise + sell = income-level tax, so 37% fed + state tax
If exercise + hold for LTCG, pay 23.8% LTCG + state tax.
Thanks for the detailed write up, this is extremely helpful. I definitely hear you on the LTGC vs STCG. It's been a common topic of discussion among my colleagues, and most of them seem to be completely focused on LTGC. They aren't considering the possibility of the stock tanking or the AMT implications. It seems like it is a wise idea to simply avoid dealing with AMT.
interwebopinion
Posts: 164
Joined: Thu Aug 13, 2020 6:21 pm

Re: First time dealing with ISOs, unsure what to do

Post by interwebopinion »

Take some money off the table - perhaps about 50%. Then optimize the other 50% for long-term tax treatment. This will protect you against the downside, while giving you some future upside.
User avatar
Tamarind
Posts: 2516
Joined: Mon Nov 02, 2015 2:38 pm

Re: First time dealing with ISOs, unsure what to do

Post by Tamarind »

The most common thing that happens to pre-IPO ISOs is that they never become worth anything. That's what happened to mine and I'm glad I exercised only a token amount when I left that company.

I subsequently worked at a public company that had swapped to handing out RSUs because so much of their pre-IPO workforce got burned by their ISOs. Company went public and the stock price then dropped such that options were deep underwater, and still are years later.

You've had a good outcome so far, but it's important not to overlook the element of luck/risk both now and in the future.

Definitely don't do option 4. There's no benefit I can think of to leaving it all on the table.

Personally I likely wouldn't exercise shares I wasn't prepared to sell on the spot, based on my own experiences, but I am also married so my tax situation is pretty different from yours despite same gross income. I'm sure there is a middle ground. Let's do some very rough math.

Let's say you exercised everything now. You're currently in the 32% marginal bracket and selling everything would put you into the 35% bracket for one year. So holding for a year instead would be a gamble for the difference between the 15% LTCG and 32-35% STCG (I get about $85,000 but you do your own math) vs ~$75,000 AMT plus risk of loss. So would you pay an extra ~$10k in tax this year to avoid the risk of loss between exercise and sale?

On the other hand the STCG tax is gone once paid but the AMT credit can be gradually recovered and as long as you stay in the 32% marginal bracket I think you'd be able to use some of it. People do get stuck with unusable credits sometimes if income drops later. But this factor would increase your cost of derisking. To evaluate this, do a mock tax return imagining it's the year after exercise and you're paying the LTCG and trying to apply your AMT credit, then another for the following year. Get an idea how long it would actually take you to recoup.

For a more gradual approach, Interwebopinion's suggestion is sound too. The right split is going to be based on your own cash on hand, other contributors to your taxable income, and whether you have other investing opportunities for the money. This is a good problem to have, so congrats!

Whatever you do, remember to sell no later one year from exercise as there's no further tax benefit to holding after that. At that point consider the old saw about "if you had the cash value already would you choose to buy and hold your company stock".
Post Reply