Why Exercising Employee Stock Options When Markets Are Down Could Make Sense

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Late last year,


Tesla

CEO Elon Musk conducted a poll—on


Twitter
,

of course—to ask if he should sell 10% of his stake in the company. His millions of followers overwhelmingly voted “yes.”

The main reason for the sale was that Musk needed a huge amount of cash to pay for the purchase of shares and to pay taxes on an employee stock grant he received in 2012. The exercise price was $6.24, which is what he paid for the stock. His brokerage then sold the shares for over $1,000 each.

Advisors who are new to the complexities of options may want to partner with an experienced tax consultant when offering advice to clients.


Kuprevich/Dreamstime

His timing turned out to be impeccable. He sold near the high in


Tesla

(ticker: TSLA), which just split 3-for-1 and now sells for $293 (or rough $879 pre-split) since markets have since dropped, especially for fast-growing tech firms. 

But he also had a big tax bill on the sale of the options, less the exercise price. Basically, in the eyes of the IRS, he had gains of over $1,000 gain on each share.

If Musk had waited to sell this year, his gain would have been less. Investors shouldn’t let the tax tail wag the dog, but the fact is that with lower stock prices, there may be some tax advantages for exercising options. 

 “While there are of course many factors to consider before exercising your incentive stock options, a lower stock price may be an attractive incentive to do so,” said Ken Van Leeuwen, CEO and founder of Princeton, N.J. financial planning firm Van Leeuwen & Co.

Here’s a look at how this works and what advisors can do to help their clients:

The scenario. Suppose your client has an option to buy 10,000 shares of XYZ Corp. for an exercise price of $10. Last year, the shares hit $40 and the total unrealized gain for exercising the option would be $300,000. 

As of now, a quarter of your client’s option or 2,500 shares has vested. However, XYZ Corp.’s stock is now trading at $15. If your client exercises the option on the vested portion, his gain will be $12,500 ($15 minus the $10 exercise price multiplied by 2,500 shares). This is known as the bargain element.

The tax and financial implications for this transaction depend on the type of option. This is either an incentive stock option, or ISO, or a nonqualified stock option, or NSO, which is the most common.

For NSOs, your client will owe taxes at ordinary rates on the $12,500. It does not matter if they sell the shares or not. The employer will also report the income and withholding on a W-2 for the federal, state and FICA taxes (which are for Social Security and Medicare). 

If your client had exercised the option when ZYZ Corp’s stock was at $40, they would have paid all these taxes on the gain. 

“A lower market value reduces the bargain element and results in less taxable compensation at the time of exercise,” said James Guarino, CPA and Managing Director at Baker Newman Noyes. “At that point, the employee hopes the company’s stock value begins an upward movement so that a future sale of the stock will yield a long-term capital gain.”

For ISOs, you pay no ordinary income taxes when you exercise the option and hold the stock. But the gain on an ISO is treated as a preference item for the Alternative Minimum Tax (AMT). This is a separate tax system with the goal of making higher-income earners pay their fair share in taxes.

The good news is that the Tax Cuts and Jobs Act of 2017 increased the exemption for AMT to $73,600 for single filers and $114,600 for those married filing jointly for 2021. The law also set the beginning of the phaseout of this amount at $523,600 (single) and $1,047,200 (married). In other words, for your client’s $12,500 gain, there may be little or no impact for AMT.

Depending on factors like your client’s financial goals, it may make sense for them to exercise the option and then hold it for two years from the grant date and one year from the exercise date to qualify for more favorable capital-gains tax treatment. 

“It can be useful to exercise incentive stock options when prices are down because a client can start the waiting period for long term capital gain treatment,” said Beata Dragovics, founder of Freedom Trail Financial.

Grants from private companies. The taxes for ISOs and NSOs at private firms are generally the same. But there is an issue with the valuation of the stock.

“It’s based on a 409A valuation,” said Vieje Piauwasdy, Senior Director of Equity Strategy at Secfi. “Exercising stock options when the fair market value is lower can minimize taxes for both ISOs and NSOs. Similarly, it can decrease the tax liability when later selling those shares after an IPO because the cost basis for those shares is lower.”

Some clients may borrow money to exercise the shares. But this can pose risks. “There are layers of fees and the lender gets to participate in the upside,” said Kristin McKenna, Managing Director at Darrow Wealth Management. “If a client wants to do this, one of the things to consider is whether it’s a non-recourse loan, secured by the shares, but not the borrower’s other assets.” That means that your client’s personal assets will not be in jeopardy when the loan needs to be repaid and the amount is higher than the value of the underlying stock that was exercised. 

Advisors who are new to stock options and start to see clients who have grants, may want to partner with an experienced tax consultant to provide specific advice to individual clients.

Tom Taulli is a freelance writer, author, and former broker. He is also the author of the book, The Personal Finance Guide for Tech Professionals

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