ISO_Tax_Strategies

ISO Tax Strategies
November 2014
www.myecfo.com | advisors@myecfo.com | (650) 231-4609
1

Tax Fundamentals: ISO Taxes
Bargain Element
(Spread) = P2 – P1
Granted Exercised Sold
Price
P3 – P2
P3 – P1
P1
P2
P3
Time
2

Scenario I: Wait To Exercise Options
Tax Implications:
Ordinary Income Tax Capital Gains Income Tax AMT Implications
N/A N/A N/A
+
• Enables option holder to wait & see
• Maintains the time value of the option
• Reduces risk of cash outlay
-
• Tax rates could be higher in the future
• Might not have a choice
3

Scenario II: Exercise & Sell Shares in a “Disqualified Disposition”
a. Sell in the same year of Exercise
Tax Classification Tax Implication
Ordinary Income P2 – P1
Capital Gain P3 – P2 (Short-Term Capital Gain)
AMT No “Preference Items” Adjustment
Bargain Element
Price
P3 – P2
P3 – P1
P1
P2
P3
Time
4

b. Sell in the next year, but less than one year after Exercise
Tax Year 1 Year 2
Ordinary Income $0 P2 – P1
Capital Gain $0 P3 – P2 (Short Term)
Bargain Element
Price
P3 – P2
P3 – P1
P1
P2
P3
Time
AMT
P2 – P1 increases income as “Preference
Item”
Smaller gain than P3-
P1 because of adjusted basis
5

+
• Allows you to use money from sale
to pay off taxes
-
• Spread could trigger AMT
• Option holder needs to come up with
the money to purchase shares
• Increases risk if not sold when
exercised
6

Scenario III: Exercise & Sell Shares in a “Qualified Disposition”
Tax Year 1 Year 2 Year 3
Ordinary Income $0 $0 $0
Capital Gain $0 $0 P3 – P1 (Long Term)
Bargain Element
Price
P3 – P2
P3 – P1
P1
P2
P3
Time
AMT
P2 – P1 increases income as
“Preference Item”
$0
Smaller gain than P3-
P1 because of adjusted basis
7

Scenario III: Exercise & Sell Shares in a “Qualified Disposition”
+
• Maximum after tax benefit if P3 > P1
-
• Highest level of risk
• Requires cash outlay for
exercise and taxes
8

Case Study: John the Engineer
Client Info & Assumptions
Salary $150,000
ISOs 100,000
Strike Price $1.50
Price at Exercise Date $20
Healthcare payroll deduction $1,000
401(k) payroll deduction $4,000
Property taxes $100
Residency California
Filing Status Single
9

Strategy I: Wait To Exercise Options Key Points
Tax Situation
Federal Tax – Regular Method $29,699
AMT Method $25,930
Total Federal $29,699
State tax - regular $10,515
AMT method $5,501
Total State $10,515
Total Taxes $40,214
Average Tax Rate 26.8%
Marginal Tax Rate 34.7%
• John is close to AMT on federal, but not on state
• Significant difference between average and
marginal tax rate
10

Strategy II: Exercise All Options and Hold Key Points
Tax Situation
AMT ISO Income $1.85 Million
Regular Tax ISO Income $0
Federal Tax – Regular Method $141
AMT Method $556,575
AMT method $139,542
Total State $139,542
Total Taxes $696,317
• Exercising triggers AMT
• Large state deduction reduces regular federal tax to
$141, but John pays the higher AMT value
• John needs to come up with exercise cost of
$150,000 + $656,103 of additional taxes = $806,103
• Average and marginal tax rates are closer
• AMT related tax payments “could” be used in future
years
• By exercising, John gave up the time value of the
option
11

Strategy III: Exercise All Options and Sell in Same Year
Tax Situation
Sale Price $30
Sale Proceeds $3,000,000
Short-Term Capital Gain $1,000,000
Additional Compensation
$1,850,000
Income
Federal Tax - Regular $1,076,768
AMT method $886,216
Total Federal $1,076,768
AMT method $209,650
Total state $374,400
Total taxes due $1,451,168
Key Points
• There are no special adjustments to AMT
• Regular tax method governs since the short-term
capital gain and additional compensation income
taxed at ordinary income rates
• John needs to come up with exercise cost of
$150,000 + $1,410,954 of additional taxes =
1,560,954, but he willl have $3,000,000 from sale.
• Average and marginal tax rates are close to 50%
• Best months to exercise:
• Post-IPO: January
12

Strategy IV: Qualified Disposition
Tax Situation
Year 1 Year 2
AMT ISO Income $1.85 Million
Sale Price $30
Sale Proceeds $3,000,000
Long-Term Capital
$2,850,000
Gain
Federal Tax - Regular $141 $639,905
AMT method $556,775 $302,555
Total Federal $556,775 $302,555
State tax - regular $10,515 $374,400
AMT method $139,542 $245,373
Total state $139,542 $245,373
Total taxes due $696,317 $547,928
Average Tax Rate 34.8% 47.6%
Marginal Tax Rate 35.0% 37.1%
Key Points
• Popular method among tech professionals
• Sometimes requires substantial tax payments for th
e potential tax savings
• In this example,
it saves $247,137 in taxes initially and possibly $219
,284 in future years due to AMT credits
• While those savings are significant, it works out to
be only 15-
18% of the gain and requires substantial capital an
d substantial risk
13

Strategy V: Exercise Partial Number of Options
Tax Situation
Options Exercised 500
Cash Outlay $750
Federal Tax – Regular Method $29,699
AMT Method $29,167
AMT method $6,148
Total State $10,515
Total Taxes $40,214
Key Points
• Exercise enough options so that Regular Tax = AMT
(or close enough)
• Starts the clock on “capital gains”tax treatement
• Not much in cash outlay, no extra taxes (or very little)
14

Summary: MYeCFO General Beliefs
1
Many employees overestimate the tax savings from converting ordinary income
into capital gains.
2 The option has value that is lost when it is exercised early.
3
There is an opportunity cost to pay for the shares and pay for the taxes on the
shares.
5 We typically recommend waiting as long as possible to exercise.
6
If you are going to exercise early, we recommend staggering the exercise dates
over years, modeling out AMT tax exposure, and exercising during December
(Pre-IPO) and January (Post-IPO)
15

Disclosures:
Non-deposit investment products are not FDIC insured, are not deposits or other obligations of MYeCFO,
are not guaranteed by MYeCFO, and involve investment risks, including possible loss of principal. The
information contained in this article is for informational purposes only and contains confidential and
proprietary information that is subject to change without notice. Any opinions expressed are current only as
of the time made and are subject to change without notice. This article may include estimates, projections,
and other forward-looking statements; however, due to numerous factors, actual events may differ
substantially from those presented. Any graphs and tables that make up this article have been based on
unaudited, third party data and performance information provided to us by one or more commercial
databases or publicly available websites and reports. While we believe this information to be reliable,
MYeCFO bears no responsibility whatsoever for any errors or omissions. Additionally, please be aware that
past performance is no guide to the future performance of any manager or strategy, and that the
performance results displayed herein may have been adversely or favorably impacted by events and
economic conditions that will not prevail in the future. Therefore, caution must be used inferring that these
results are indicative of the future performance of any strategy. Index results assume re-investment of all
dividends and interest. Moreover, the information provided is not intended to be, and should not be
construed as, investment, legal, or tax advice. Nothing contained herein should be construed as a
recommendation or advice to purchase or sell any security, investment, or portfolio allocation. Any
investment advice provided by MYeCFO is client-specific based on each client’s risk tolerance and
investment objectives. Please consult your MYeCFO Advisor directly for investment advice related to your
specific investment portfolio.
16

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