7 Tax Hacks for Incentive Stock Options
Incentive Stock Options were created by the government to give employees a tax benefit way build companies. Ironically, it’s one of the most booby-trapped forms of equity out there. As such, a few tips can go a long way. Here are 7 ways to reduce or avoid paying taxes on your incentive stock options.
How to reduce taxes when EXERCISING
Exercise when the Stock is down
“Incentive Stock Options were created to be a tax benefit [...] Ironically, it’s one of the most booby-trapped forms of equity out there. ”
While you certainly shouldn’t hope for a decline in your stock’s value, in the case the value does decline, it presents some savvy opportunities to save on taxes. When you exercise, you may be taxed on the spread (between the exercise price and the fair market value)—at either ordinary income or the Alternative minimum tax (AMT). When the stock is down, your spread may be so small (or non-existent) that you could reduce or completely avoid being taxed. It’s common for private companies whose stock declines to completely re-issue grants at a newer and lower strike price. When they do this, oftentimes, the strike price the FMV are the same. How much spread is in between a $3 strike price and a $3 FMV? None! That means no taxes upon exercise! Of course, you’ll want to ensure your stock options are in-the-money or at-the-money.
Who said you can’t make lemonade out of lemons?
2. No AMT here…AMT Crossover
If you can afford to purchase the shares (both financially and from a risk perspective), and it aligns with your goals, then this strategy should be implemented at a minimum. Thanks to an AMT exemption (see part 2 of Form 6251), most people have an AMT liability that is less than their regular tax liability. AMT is only applicable when your AMT liability exceeds your regular tax liability. So what does that mean? Well it means, you can continue to exercise your incentive stock options until your AMT liability approaches (but doesn’t exceed) your regular tax liability. This essentially allows you to shelter that income from being taxed.
AMT crossover is an opportunity that can supplement almost any other equity strategy you’re implementing. So even if you want to do a cashless sale, exercise NSOs, or selling previously exercised ISOs, this strategy can supplement and enhance your current approach. The one problem with this approach is that this doesn’t bode well in year where you’re trying to recoup the AMT tax credit.
3. AMT Rate Stealing
If your tax bracket is higher than AMT’s rates (26%-28%), this one’s for you. When you’ve triggered enough AMT, subsequent income earned, will only increase your NET tax bill by AMT’s rate. You can earn additional income (NSO exercises, Roth conversions, short-term capital gains, etc.) at a more efficient tax rate.
This one can be a difficult to grasp so I’ll use an analogy. Imagine two cars in a race. The one in the lead is traveling 28 mph. This car in the lead represents an AMT bill exceeding your regular tax bill. Your regular tax bill, is analogous to the car in second place, traveling at 37 mph. Their speed is respective of the tax rate in this analogy. The distance traveled by the first car represents the net tax bill. If you give each of these cars an hour to drive, the car in front will have only traveled 28 miles. In other words, if you earn $100 worth of income, your net tax bill will have only increase by 28%. The car in second place did travel 37 miles, but it didn’t surpass the first car (traveling only 28 mph). The distance between the cars decreased—meaning, your AMT decreased. This is because the second place car was traveling faster than the one in first place.
When you have an AMT tax liability, you can earn additional income (NSO exercises, Roth conversions, short-term capital gains, etc.) at a more efficient tax rate—AMT’s tax rate.
If that didn’t quite make sense, you might find this visual explanation of AMT rate stealing useful.
To be clear, this doesn’t lead to a lower tax bill, BUT it can lead to a more efficient tax rate for the year. In addition, AMT in theory, is a temporary tax whereas your regular tax bill is more permanent. So in effect, this approach is reducing the temporary tax to optimize the tax rate. You’ll want to ensure this approach makes sense for your situation.
4. Early Exercise: 83(b) Election
This approach applies specifically to AMT which is very much correlated with incentive stock options (ISOs). If your company allows you to exercise your shares before they vest (also known as early exercising), then Section 83(b) is something you’ll want to look into. Similar to the first approach, where you exercise while the stock was low, this approach is also taking advantage of a small spread between the strike price and FMV. Early exercising and filing an 83(b) election can reduce or eliminate your tax if there’s subsequent appreciation. When you file your 83(B) election, you are paying taxes now, rather than later. As such, you need to understand that there’s risk in locking in your tax bill—especially if the stock loses value. Don’t do this approach if you plan on doing a disqualifying disposition.
Free Tax Guide
5. Income Tax Planning
The whole premise to income tax planning is to earn your income more efficiently. Through strategic tax planning, you can get your earned income into a lower tax bracket. What are some ways that works? Among many options, you might consider 401(k) contributions—which defers the taxation of the income later. This effectively reduces the amount of income being taxed this year. If applicable, you may be able to make a deductible contribution to a traditional IRA or an HSA. You could be strategic about when you exercise and which tax year to lower your net tax bill throughout the years.
6. For early Employees and founders (QSBS)
Out of all of the tax benefits available to you in the tax code for incentive stock options, Qualified Small Business Stock (QSBS) is hard to beat. Unless you’re making $100’s of millions, I don’t think you can beat this tax hack. This tax cheat code (Section 1045) can enable you to sell up to $10 million dollars worth of equity tax free—compliments of the federal government. Some states may honor this from a state income tax perspective (such as New York), while others do not (California). There are a few rules that would enable you to receive such a benefit. For example, the company must be a C Corp, and you must have exercised (purchased) the shares before the net assets of the company exceed $50 million. If you can pull this off, it’s definitely worth your time. Off the top of my head, I can’t think of anything else in the tax code that would give you $10 million tax-free (maybe a roth IRA if you’re lucky to grow it to $10 million).
While the tax benefit is received when you sell the shares (not during exercising), I like to put it here to remind people that the shares need to be exercised within the limitation in order to qualify.
Saving taxes when SELLING ISOs
7. Selling for a loss: Tax Loss Harvesting
When the stock is down, people tend to make impulsive, rash decisions—but if you know what you’re doing, a down market can present a great opportunity to save on some taxes. When you sell your stock for less than your purchase price, you can use that loss to offset other income. The government doesn’t want you to take advantage of the loss and then purchase the stock right back. As such, they created something called the Wash-Sale Rule. This rule prohibits you from purchasing company stock 30 days before you sell for a loss, the day you sell for a loss, and 30 days after you sell for a loss—Totaling 61 consecutive days where you cannot purchase company stock. While that might seem easy to do, equity compensation can bring some added complexity.
Save on Taxes
While capital gains and losses get offset, the caveat is that you can only use $3k worth of capital loss to offset ordinary income (higher tax bracket) per year. The good news, any unused losses can be carried forward indefinitely and used in subsequent tax years.
I know I promised 7 tax hacks, but who doesn’t appreciate some freebies? Here’s 4 more…
8. The only dedicated benefit for ISOs—Qualifying Disposition
Incentive stock options were created by Section 422 of the Internal Revenue Code to incentivize people to build and hold startup equity. To create this incentive, the IRS leveraged tax incentives. If you hold incentive stock options at least two years from the grant date, and one year from the date of exercise, then the gain is treated as long-term capital gain. Going from the highest ordinary income tax bracket (37%) down to the largest capital gains rate (20%) is a 17% tax savings.
9. Dodge THIS AMT DISASTER: AMT Phaseout
When learning about AMT, you probably learned that it has two tax rates—26% and 28%. If you pull up the AMT tax form (Form 6251), you’ll easily find that to be the case. Not too shabby when looking at the surface. Unfortunately, AMT is worse than you thought. Keeping the theme of unnecessary complexity, AMT has out-done itself…again. Through a series of convoluted calculations, AMT can actually tax you at 35%.
Here’s the rundown: The AMT was created to tax the wealthy who successfully tax-planned their way to avoiding taxes. To ensure only the wealthy were the only ones being taxed by this (and not the average joe), the IRS added an AMT exemption (see part 2 of form 6251) to reduce the AMT. Depending on the amount of AMT you trigger, you could be triggering so much AMT that the government knows they’ve found the one they’re looking for—someone with a lot of gain. Once you hit that threshold, the IRS starts to take back their AMT exemption. For every dollar you earn, they take back a quarter of the exemption. It’s this phaseout that causes AMT to tax things at 35%.
10. Section 1244
When talking about the benefits of Tax-Loss Harvesting (TLH), there was a caveat—you can only write off $3k worth of ordinary income with a capital loss per year. This tax hack, circumvents this downside to enable you to save more on taxes. If you stock declines, losing most—if not all—of it’s value, then you’re in luck. While having your stock go to $0 isn’t a good first choice, this makes as a good back up if it does. It’s not as simple as applying to everyone as only a few certain types of companies actually qualify.
11. Gifting to Charity
How can you reduce your taxes? Well by not recognizing the income! If you’re charitably inclined, this can have a huge impact on your tax bill. This is an effective approach on low-basis stock which would have otherwise incurred a larger tax bill. Rather than selling low-basis stock—recognizing income on a larger gain—you can gift the stock. When you gift your stock, you essentially receive two benefits: avoiding paying taxes, and potentially a charitable contribution.
As an alternative, you could gift the low basis stock to a family member in a lower tax bracket. While you eliminate the possibility of getting a charitable deduction, you do get that income earned at a lower tax rate.
Saving taxes is DUMB
This is a hill I’m willing to die on. When most people start to learn about taxes, they dangerously start to frame all of their thinking to optimize for taxes. Yet, there’s a saying, “don’t let the tax-tail wag the dog.” To help you understand this better, I’ve created a money decision framework that helps you make smart money decisions. The problem is…Taxes aren’t the most important thing. In fact, there are at least 3 things that I’ve identified that are more important than taxes. You can learn what those are here…
