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The Incentive Stock Option (ISO) Strategy You Need to Know

I’ve helped clients exercise millions of dollars in Incentive Stock Options (ISOs), but exercising is only the start.


To take full advantage of your equity, you need a well-thought strategy like the one I'm about to share.


Here’s one of my favorite strategies for Incentive Stock Options.


Exercising ISOs Early in the Year

The early year ISO exercise is one of my favorite strategies for two reasons:


  1. When timed correctly, you can sell in a tax-advantaged qualifying disposition before the AMT bill is due.

  2. It gives you the longest timeframe to decide whether you should hold shares into the next tax year or “bail out” before year-end.


This post will show you how you can benefit when the stock price climbs or save you thousands in taxes if it falls. If you want to understand the intricacies of ISO taxation, read The Executive's Guide to Incentive Stock Option Taxation.


Creating Your ISO Exercise Strategy

We'll use a hypothetical scenario to illustrate why the early year ISO exercise is so advantageous, but the first step in creating your ISO exercise strategy is projecting your income for the year to determine your estimated tax liability.


In this example, you and your spouse expect to have $425,000 of taxable ordinary income, resulting in the following tax outcome.

Tax situation with no Incentive Stock Option Exercise

On 1/31/2024, you exercise 5,000 ISOs that were granted on 1/15/2020. They have a $10 strike price and you exercise when the fair market value (FMV) is $60.


You pay $50,000 for the shares (5,000 shares x $10 strike price). Your bargain element is $250,000 ($60 FMV - $10 strike price)*5,000 shares.


The shares continue to appreciate throughout the year and you hold them into 2025.

Since you held them into a new tax year, the $250,000 bargain element is reported as income for Alternative Minimum Tax (AMT).

IRS Form 6251 highlighted to show reporting of ISO exercise on Alternative Minimum Tax.

This causes you to pay $63,827 of AMT, bumping your total tax up to $157,038. You’ll receive a credit for the AMT that you can apply to future tax years (covered below).

The Alternative Minimum Tax generated from a $250,000 ISO bargain element.

You need to account for the extra tax liability, especially since no taxes are withheld on ISO exercises. Luckily, the shares are eligible for a qualifying disposition after 1/31/2025. So, if the shares appreciate or hold their value, you can sell them before 4/15/2025 and have liquid funds for the tax bill.


Selling in a Qualifying Disposition and the AMT Credit

Let’s say you sell the shares for $360,000 ($72/share) on 2/5/2025. Now, you have cash to pay the 2024 tax liability, and the 2025 tax liability isn’t due until 4/15/2026.


Since 100% of the AMT you paid was due to the ISO exercise, you’ll have a $63,827 AMT credit for future tax years when you aren’t subject to AMT. So in 2025, you have the exact same ordinary taxable income, but you have to account for the gain on the ISOs you sold. Since you held the exercised shares into a new tax year, they have dual basis. One for ordinary tax and one for AMT.


The $250,000 bargain element was never reported for regular tax, so your regular tax basis equals the $50,000 you paid for the shares. This results in a $310,000 long-term capital gain for regular tax.


This gain flows through to your AMT calculation, but you’ll also report a NEGATIVE adjustment of $250,000 to account for the ISO bargain element you were taxed on in 2024.

IRS Form 6251 showing the reporting of a sale of ISO shares

Since you have a substantially higher gain for regular tax purposes, you aren’t subject to AMT in 2025. This leaves you with a regular tax of $143,762 and AMT of $71,192, not including the Net Investment Income Tax (NIIT) and Medicare surtax. However, this is where the AMT credit comes into play.


Since the difference between AMT and regular tax is $72,570, you get to apply the whole $63,827 AMT credit to your regular tax liability, reducing it to $79,935. If the difference between the regular tax and AMT was only $30,000, you would only apply $30,000 of the credit and carry forward $27,651.


After accounting for the NIIT and Medicare surtax, your total 2025 tax bill (paid in 2026) is $93,553. That’s an all around great outcome, but what happens if the stock falls drastically after you exercise it?


That’s where the early year exercise is helpful if you need to “bail out” of exercised ISOs.


Bailing out of Incentive Stock Options

Bailing out means selling ISO shares before year-end to purposely trigger a disqualifying disposition and avoid AMT. Why would you want to bail out?


In the previous example, the stock price appreciated by 20%, but what if the stock was down 50% by November? Believe me, I've seen a client’s stock price get cut in half in less than a month.


In this case, your shares are now worth $150,000, but if you hold the shares into 2025, your 2024 tax bill with AMT is still $157,038.


How does bailing out help?

By selling and triggering a disqualifying disposition, you convert the ISO bargain element into compensation income in 2024 and avoid AMT. The bargain element you report for regular tax is $100,000 ($150,000 sale - $50,000 cost of shares). You’ll report the sale of the shares, but there won’t be a capital gain.

Illustration of tax savings from bailing out of failed ISOs

In this scenario, you pay ~$30,000 less in 2024 taxes by bailing out before year-end. Alternatively, you could hold the shares through year-end, pay AMT, receive an AMT credit, and sell after 1/31/2025 for a qualifying disposition.


However, you run the risk of the stock price falling further before the qualifying disposition date, leaving you with even less proceeds to pay the 2024 tax bill. In addition, it can take years for you to recover the full AMT credit due to the AMT capital loss limitation.


Conclusion

Option planning continues long after exercise if you want to make the most of your equity compensation.


The early year option exercise is one of my favorite strategies for Incentive Stock Options because it gives you the most flexibility to determine the best tax outcome for your situation.


Disclaimer

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