WipFli: Creating your stock option strategy: When to exercise, sell, and hold

This is a guest blog post from Chris Lockhart, CPA (Wipfli LLP) and Anthony Perillo, CFP (Wipfli Financial Advisors, LLC)

If you’ve received stock options from your company, you may wonder what’s the best strategy for exercising those stock options going forward. Compared to other forms of compensation, stock option awards give you a unique set of decision points and potentially allow you some control over both the tax treatment and timing of when you recognize income.

They also give you the opportunity to take an ownership stake in the company. By awarding you an asset driven by the performance of the business, the company is incentivizing you to work hard to ensure it performs well, which drives up the stock price and makes your options more valuable.

The importance of having a stock option strategy

Risk is a big factor when it comes to stock options. After all, the company might not continue performing well. Your own needs come into play, too. Are you looking to buy a house soon or pay off debt? How long do you plan on being with your company? What are the tax consequences of exercising? If you plan to hold the stock rather than selling right away, do you have other liquid assets you can use to pay the tax?

It’s important for you to create a strategy around when to exercise stock options and whether to sell, hold or some combination of both.

What choices you make may depend on what type of stock options you’ve received. Let’s look at the two most common:

Nonqualified stock options (NSOs): With NSOs, your company gives you the right to purchase company stock at a fixed price (the “exercise” or “strike” price) within a certain timeframe. Let’s say you receive the option to purchase 100 shares at the price of $10. Assume that the company stock is trading for $10 at the time of the grant and your options have no ascertainable market value. In that case, there are no tax consequences upon receiving the grant. There’s usually a vesting period (e.g., two years). If, after those two years, the stock is trading at $25 a share, you can exercise your options at $10 a share and receive a built-in $15 gain. This gets reported on your W-2 as ordinary income.

You now need to make the decision of whether to sell or hold. You can do a same-day sell (also called a cashless exercise), which requires no cash to exercise and provides you with a lump sum cash payment. But if you believe the company will continue to perform well and raise the stock price further, you may want to hold the stock and participate in the growth of the company.

Note that this “exercise and hold” strategy requires not only the cash to exercise the options but also a way to pay the income and payroll tax withholding. You may need to pay your employer to cover the tax, or it may be possible to cover the taxes in a different way, like having your employer withhold them from other wages or deliver a reduced amount of stock to you.

If you hold for longer than one year from the date of exercise, the difference between that $20 and whatever the stock grows to gets treated as long-term capital gains. For example, if five years from then, the stock is sold at $50, then the $30 difference is not treated as ordinary income but rather capital gains — and that’s more tax efficient for you.

Incentive stock options (ISOs): An ISO may provide the same right to exercise stock as an NSO, but the tax treatment may be vastly different depending on if you hold the shares for a year or immediately sell them. If you exercise and hold the shares, there is no ordinary income tax event, but the difference between the exercise price and fair market value of the stock is an adjustment to alternative minimum taxable income.

For example, assume you exercise an ISO option with a strike price of $15 and a fair market value of $20 and hold the shares. You will have a $5 adjustment to your alternative minimum taxable income on that year’s tax return. This adjustment could cause you to be subject to alternative minimum tax (AMT). Depending on your tax situation, this may lead to a minimum tax credit that you can take in future tax years.

If you hold for more than a year from the date of exercise, and you’re at least two years out from the date the ISO was granted to you, then any gain or loss on the disposition of the stock results in capital gain or loss treatment.

If the stock is sold sooner than one year from the date of exercise and two years from the date of grant, it is considered a “disqualifying disposition,” and your ISOs lose their preferential tax treatment. In that case, the difference between the exercise price and fair market value on the date of exercise is taxed as ordinary income.

Should you sell or hold?

Holding your options once you exercise them can be more tax efficient for you, but it also comes with the risk that the stock won’t continue going up. It also requires you to plan for how you’ll come up with the cash to pay the strike price and any taxes due as a result of the exercise.

You may, in fact, choose a third option, where you sell some percentage of your option award and hold the rest. This can give you enough cash to cover your liquidity and tax needs but still give you the benefits that come with holding.

Ultimately, whether you choose to sell, hold or some combination of both should depend on a number of factors: your appetite for risk, where you are in your career, your time horizon as an investor, what other assets you own, what your liquidity needs are and how mature your company is, to name a few.

While there is no black-and-white right answer for each person, there are pros and cons to each choice you can make. Weighing them all — and taking into account the total picture of your life, goals and future needs — allows you to make a more educated decision.

Getting the advice of professionals

In the tech startup world, stock options create a sudden windfall making up a significant portion of a person’s income. It requires big decisions for someone early in their career. And it can come with big surprises.

Many aren’t aware that their withholding often isn’t enough to cover exercising their NSO options or that exercising their ISO options will potentially create AMT tax. Come April, they’re hit with a surprise tax bill that they are not prepared for.

Creating a stock option strategy is most effective when you leverage the expertise of a CPA and a financial advisor. They can help you navigate the tax impact, risks and benefits of each choice. They can also help you create financial goals, identify a path to achieve those goals and determine how to best use your stock options.

Financial planning tools model what your net worth looks like now and what it could look like 10, 30, 50 years into the future. It helps you make more well-informed decisions on how to best use your money, create greater wealth and secure your financial future.

Note that all of the tax consequences discussed above are applicable as of the current date, and future tax law changes could impact the tax implications of different strategies. Those potential tax law changes mean that now is a good time to connect with a CPA and a financial planner to begin your stock option planning.

Click here to learn about Wipfli Financial’s interactive financial planning, and connect with Wipfli LLP to talk about stock options and tax planning.

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