Incentive Stock Options: Avoid Costly Mistakes

Understanding Incentive Stock Options and Potential Windfalls

A significant motivator for dedicated employees of private companies is the potential to benefit from vested incentive stock options (ISOs) when the company eventually becomes public.

This aspiration is perfectly reasonable. Many individuals envision utilizing the proceeds from these options to achieve financial goals such as early retirement, homeownership, student loan repayment, global travel, or philanthropic endeavors.

Navigating the Complexities of Stock Awards

However, most employees find themselves largely unsupported when attempting to understand how to realize value from their stock awards.

While employers often acknowledge a need for improved communication regarding ISOs, they are typically restricted from providing personalized financial advice due to legal constraints.

Consequently, many employees proactively seek guidance from a qualified, fiduciary financial advisor to explore various cash-in scenarios.

A Real-World Illustration

Consider the case of Kurt, a 50-year-old VP of product management at a recently public healthcare startup.

Over three years of service, Kurt accumulated 350,000 ISOs, representing an approximate value of $6 million.

Unlike some, Kurt didn’t intend to immediately retire; he aimed to use the funds to purchase a vacation home and diversify his investment portfolio, a plan that carried substantial, and initially unrecognized, tax implications.

The Impact of Timing on Tax Liability

Exercising and selling ISOs within a year would result in profits being taxed as short-term capital gains, treated as ordinary income.

To demonstrate this, a hypothetical scenario was created. If Kurt were to exercise and sell all his ISOs immediately, he would face approximately $6 million in ordinary income, potentially pushing him into the highest tax bracket and incurring nearly $3 million in combined federal and state taxes.

Alternatively, a staggered exercise strategy, coupled with a holding period of at least one year before selling, could significantly reduce his tax burden.

Leveraging Long-Term Capital Gains Rates

This is due to the unique characteristic of ISOs, allowing for potential long-term capital gains rates upon sale, which are often lower than ordinary income rates.

This approach could potentially save Kurt up to $1.5 million in taxes compared to the immediate exercise and sale strategy.

It’s important to note these were hypothetical projections, and actual results would depend on market fluctuations at the time of sale; a price decrease could reduce the windfall, but also lower the capital gains tax.

Strategic Implementation and Future Planning

Ultimately, Kurt opted for the less-taxing “exercise and hold” strategy, liquidating a portion of his ISOs annually.

In the first year, he successfully sold enough shares to finance his vacation home.

He now plans to invest future proceeds to further enhance his retirement savings and achieve other financial objectives.

The Increasing Prevalence of IPOs

While such situations were once uncommon, the surge in global IPOs in 2020, with continued growth expected, suggests that more employees may soon find themselves in a similar position.

Options Beyond a Public Offering

Furthermore, even if a company doesn't go public, employees may have the opportunity to exercise vested ISOs using private shares when leaving the firm.

The value of these shares is determined by an IRS Section 409A valuation, conducted annually.

The same tax considerations apply to private shares, reinforcing the value of consulting with a qualified fiduciary financial advisor.

The Importance of Holistic Financial Planning

Whether working with a professional or managing ISOs independently, it’s crucial to evaluate the potential impact on your overall financial situation, particularly your tax liability.

Given the substantial stakes involved, making decisions without a comprehensive understanding is strongly discouraged.

Disclaimer: WorthPointe, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission (SEC). Registration does not imply a specific skill level or training, nor does it constitute an SEC endorsement. A copy of WorthPointe’s current disclosure brochure is available on the SEC’s website at www.adviserinfo.sec.gov. The client featured in this article was referred to WorthPointe Financial Planners through Wealthramp.