The Magic ISO Exercise Window

By: Joe Ferreira, Jack Rabuck, and Sam Marshall, CPA

Every New Year’s Day, an opportunity arises for employees at public companies (or those with liquid secondary markets) with highly appreciated Incentive Stock Options (ISOs). ISOs are great (especially highly appreciated ones!), but many people think they can’t capture the tax benefits of ISOs because the total exercise costs – cost to buy the shares and the alternative minimum tax (AMT) – are too high. They incorrectly assume they will have to sell the option and pay ordinary income rates on their gains. 

But due to a quirk in the timing of when income is realized and when taxes are due, this isn’t always true.

It’s common for investors of all stripes to not sell stocks in late December to avoid paying taxes on them in April. Waiting to realize gains a week or two can push off the tax bill by a whole year. 

What does this have to do with ISOs? More than you’d think. If you exercise a large number of ISOs in July, you might owe a sizeable chunk of AMT in April the following year. If you don’t have other assets on hand to pay that tax bill, you will have to sell some of the shares you exercised in July, diminishing the benefits of exercising, as those shares will be subject to short-term capital gains treatment given they were held for less than one year.

But what if you exercise in January, February, or March–the magic window? In this scenario your AMT bill is due in April the following year, after the shares you exercised crossed the threshold for long-term capital gains. You would still have to sell some shares to cover the tax, but far fewer than you would have if they were subject to short-term capital gains. 

This savings can make a huge difference for your finances. For one client we just assisted through this type of scenario, the estimated savings by shifting from short-term gains to long-term was over $500,000! 

Many people are convinced that they will never be able to afford to buy their options, or at the very least, that they’ll have to do an inefficient ‘cashless exercise.’ If you know about the special window that opens for a few months at the beginning of each year, you have a huge advantage. The recent pullback in many technology stocks might also create an opportunity to further reduce your 2022 AMT bill.

This strategy isn’t for everyone. Exercising a large amount of ISOs can trigger a very large AMT bill which could force you to sell some shares to cover the tax. This is something you’ll likely want to do anyway (unless you can come up with the cash elsewhere), but you do have to be willing to sell some shares. If you have any questions, we’re here to help.