Incentive Stock Option (ISO) Planning Guidelines

According to the NASPP, Incentive Stock Options (ISOs) are now rarely granted to employees of publicly traded companies, yet they are still popular with pre-IPO private companies. Consequently, advisors may encounter clients or prospects with ISOs that want to take advantage of the lower Alternative Minimum Tax (AMT) tax rates on these grants and optimizing for tax efficiency.

Financial advisors often turn to us for an easy way to deal with Incentive Stock Options. Unfortunately, there is no simple way to do an ISO/AMT tax analysis. Modeling the tax effects of ISOs is a complex process and explaining the results to clients is even harder. However, there is a great tool that can help.

StockOpter Pro was developed during the “dot-bomb” era when ISOs were prevalent along with the negative consequences of handling them poorly. This Excel based application facilitates ISO/AMT tax planning, but it still takes a high level of expertise to enter all the assumptions, model the scenarios and interpret the results. So in the course of supporting StockOpter Pro over the years we’ve developed a handful of helpful ISO planning guidelines that can avoid the brain damage associated with running a detailed tax analysis for individuals with these stock options.

1. ISOs shouldn’t be exercised for tax reasons! You need to determine for “investment” reasons if an ISO grant is “ripe” for exercise. A good rule-of-thumb for this is any grant with an Insight Ratio of less than 15%.
2. If you recommend exercising and holding an ISO for the 1 year holding period to take advantage of the lower AMT tax rate YOU are on the hook to monitor the stock during this period (don’t expect the client or their CPA to do this for you). The AMT tax liability is established upon exercise so big declines in stock price can mean the client may owe more in tax than the stock is worth.
3. Exercise ISOs in January. This way the client doesn’t have to deal with multiple tax years and you’ll have 12 months to monitor the stock price. If the stock price goes below the exercise price you can sell the underlying stock during the holding period. This is called a disqualifying disposition and the option proceeds are taxed at ordinary income rates like non-qualified stock options.
4. The AMT tax rates are only between 3-9% lower than ordinary income tax rates depending on the bracket and there is a lot of risk associated with holding the stock. Consequently, our rule-of-thumb is if the recipient isn’t real confident that the stock will be at least 7% higher after the 12 month holding period they are better off exercising and selling the ISO (disqualifying it) rather than exercising and holding.
5. Before doing an ISO/AMT tax analysis, advisors can setup a StockOpter.com account and run an Equity Compensation Risk Analysis. Use the StockOpter.com client deliverable as a framework to discuss the risk issues of the client’s company stock and option holdings and these ISO tax guidelines.

If the client is interested in the tax benefits provided by Incentive Stock Options, you have a couple of options for running an ISO tax analysis.  The best approach would be to use StockOpter Pro.  Check out the free demo or schedule a webinar walk-thru.  StockOpter Pro is designed to model and compare the after tax results of multi-year ISO exercise and sale strategies.  Optionally, you can turn over the analysis process to the client’s CPA, but then you are out of the loop.  It’s advisable to model the ISO strategy with StockOpter Pro yourself and then provide the detail to the client to review with their CPA.

We hope these guidelines make dealing with Incentive Stock Options a little easier.

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