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Incentive Stock Options: Plan for Alternative Minimum Tax (AMT) Considerations

November 21, 2023 | By Jack Meccia, Managing Director of Tax Strategy, and Joe Meccia, Managing Director of Tax Planning of Allegoriq, LLLP
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For employees at late-stage private companies, having Incentive Stock Options where the 409A valuation (or, stated simply, the current valuation) exceeds the grant price might feel like buying a new home that requires renovating. Your cynical side wonders whether the home is actually worth what the appraiser says, and if you should really be putting any additional money into it. Your pragmatic side embraces that this wealth-building opportunity could build a legacy. 

To stick with the home renovation analogy, even if you think you know where the pipes are, you should still hire professionals to work on the electrical and plumbing. In this case, we recommend working with advisors who understand the ins and outs of equity compensation and related tax concerns. 

In this Insight, we highlight some of the most important related concerns, including three characteristics of the alternative minimum tax (AMT), and how they can be applied to the tradeoffs that come with exercising a stock option.

Should you exercise an “in the money” stock option?

Let us assume you have unexercised stock options at a late-stage private company. Let’s also assume that the options are vested. And, significantly, that the 409A valuation per share of common stock exceeds the grant price. The latter means the option is “in the money.” This term bears emphasis because while valuations can change, an in-the-money option signifies that the company’s appraiser believes, in its professional opinion, that the option is worth more than the cost to acquire it. 

Does this mean you should exercise it?

Here's where tax and wealth management considerations enter the picture. If it costs $1 to buy an option that the company’s appraisers say is worth $10, then the IRS (and potentially states and localities) will want to share in the opportunity by imposing taxes. Even if you can afford the $1 grant price, the funds you use to pay the grant price and taxes change the composition of your personal balance sheet and might foreclose certain financial or investment opportunities.

How do expiration and tax rates create urgency to exercise stock options?

Let’s start with the main reasons why it might be necessary to exercise stock options sooner rather than later. The first is expiration. The specifics differ widely, but options expire, and if the option is not exercised in a timely manner, then you lose the ability to buy stock at a discount. 

The second is for better tax treatment. The specifics vary widely, but in general, if you hold an option for more than a year from the date of exercise (and, for Incentive Stock Options, two years from the date of grant), then upon selling the stock, the gain is subject to a lower tax rate. 

How much lower are these taxes? 

Again, the specifics and mechanics vary based on state residency and other factors. But let’s consider solely the federal tax side. Savings are ~15%, which, is the difference between the 23.8% top long-term capital gains and net investment income tax and the 37% top federal tax rate for ordinary income plus medicare taxes. 

On a large stock position, those tax savings are considerable. Especially when the difference, re-invested over multiple decades, compounds in the form of investment returns. So, if options can expire, and the tax savings from long-term capital gains are significant, then the prospect of exercising merits close examination. Which brings us back to cost.

AMT and Incentive Stock Options

When you exercise an ISO, there are two types of cost. The first is the grant price. From the example above, the $1, which is due at exercise. The second type of cost is the Alternative Minimum Tax. It’s true that some number of ISOs can typically be exercised before reaching AMT. But let’s turn to what happens under AMT rules.

AMT is an alternative tax system. One of its features is to tax the difference between the 409A per share of common stock and the grant price. Let’s assume for simplicity that tax is 28%. We can summarize that 28% rate for AMT by highlighting three characteristics:

  1. Deposit: AMT created from an exercise of ISOs is like a tax deposit. The deposit is paid for the tax year you exercise. The reason you consider paying the deposit is to achieve a lower rate of tax at the point the stock is sold, later, assuming the long-term holding period is met. You can theoretically recover some of the AMT in years where you have high ordinary income and most significantly, the sale of stock that generated the underlying AMT. That’s where the potential 15% tax savings come in.
  2. Amount of deposit: The second characteristic is that the amount of the deposit is based the 409A per share of common stock at the point the ISO is exercised. This means that if the 409A increases later (say, from $15 to $40), you will benefit more by exercising and holding at $15 than at $40. The “spread” that counts towards calculating your AMT payment will be lower at $15, thus you will have less of a deposit that needs to be made in the year of exercise.
  3. Don’t write a deposit check you can’t afford: The idea of the deposit is to preserve the pursuit of the 15% tax savings, which becomes more valuable if things go well, because it’s correlated with the tax on the value at eventual sale. But when things don’t go as well as you’d hoped, you can be left with unutilized AMT credits. Starting in 2026, most people without a condition that accelerates AMT recovery will find it even tougher to recover AMT credit each year.

With these three characteristics in mind, let’s take a closer look at an example that applies these characteristics of the AMT to a more detailed example.

ISO Alternative Minimum Tax Example: Key Tradeoffs

In this example, assume 100,000 ISOs are vested, and each has a $1 grant price. The per-share 409A valuation is $20. The company raised a Series D one and a half years ago. It’s rumored that family offices are interested in acquiring stock at $30 per share of common stock. The company has been valued at $2B. 

  1. Tradeoff 1 – Pre-empting a 409A Increase

    Because AMT is measured based on the 409A at exercise, the potential AMT to acquire the 100,000 ISOs at a $20 409A is significantly lower than at $30. Your financial advisor will be best positioned to advise on the opportunity cost of an ISO exercise. Your tax advisor should be able to model the annualized return from exercising and holding ISOs as a function of eventual exit prices. You should be able to understand if you can afford it, and also evaluate if it’s a compelling investment opportunity.
  2. Tradeoff 2 – Asymmetric Benefits

    Let’s assume the stock is sold in a later year for $50 per share of common stock. But before considering that favorable exit, let’s examine an especially favorable tenet of ISO tax treatment. Remember that a grant of 100,000 vested ISOs where the per-share 409A valuation is $20, with a grant price of $1, means that when initially granted, the options were worth $1.

    With ISOs, it’s still possible to exercise and hold at a $20 per-share 409A (so ~$5.32 of AMT deposit or 28% multiplied by the spread of $19) to open the door to a 15% lower tax rate in the future. Once activated, that 15% lower tax rate is not on the first $19 of gain. Rather, if the stock is sold for $50, then the entire $50 minus $1 is subject to a 15% lower tax rate. When quantified in exit scenarios, this makes the investment return of exercising ISOs especially promising.
  3. Tradeoff 3 – Exercising is expensive, and you have already exercised more than you want to initially sell to diversify.

    The two previous points emphasized strong reasons to consider an exercise and hold, even where there’s a significant cash outlay. Let’s add to the facts that when you joined the company, you previously exercised (and filed a section 83(b) election for) 500,000 NQSOs at a grant price of $0.05, for a total cost of $25,000. And that you have 250,000 time-vested RSUs that will be released into ordinary income at the second trigger (public offering or acquisition). 

    Functionally, this means you’ll have paid $25,000 out of pocket to acquire almost 90% of the equity position (if we’re measuring gross RSU quantities). It would cost over $600,000 to acquire just 10% more. If you wanted to sell 80% of your position as soon as you’re eligible to after an IPO, you’d have the ability to do so, for only the $25,000 previous cost outlay.

    If you plan to stay at the company until it trades publicly (and that certainly involves risk, because ISOs need to be exercised quickly after a separation of service event, and layoffs can be out of your control), then maybe it’s better for your balance sheet to exercise after the company begins trading publicly, because you’d already have the quantity you’d want to diversify initially. 
  4. Tradeoff 4 – Financing

    Financing with an external capital partner, where permissible, can help reduce risk on the balance sheet. The structure of these contracts varies widely. One type of contract,  a variable prepaid forward contract, can ‘advance’ capital in a tax-free manner in the year of receipt. This is not a stock sale, so the transaction has to be structured in a specific way. The capital is paid back in a future tax year, together with the transaction costs. In these contracts, some of the transaction costs may be a capital loss for tax purposes, which can lower the true cost of financing. Financing and then waiting for the IPO to sell can more be efficient than selling the stock for a lower price in a secondary sale and using leftover proceeds to exercise. 

Learn More About Managing Your Equity Compensation to Achieve Your Personal Financial Goals

We hope this explanation of AMT and associated tax and financial tradeoffs provides valuable context when considering your strategy for exercising ISOs at a late-stage private company. Even when capital markets aren’t in full swing, the tax-advantaged status of ISOs – and the lower relative cost of acquiring them when 409A valuations are muted – are a potential call to action. 

For a specific discussion of these and more advanced planning strategies, consult experienced financial teams and tax advisors who concentrate heavily on serving those with equity compensation. 

If you have questions about how to manage your equity compensation, the Wealthstream team is here to help. We encourage you to reach out to schedule a complimentary 30-minute consultation with one of our financial planners.

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