Exercise ISOs Earlier
Exercise ISOs sooner rather than later to reduce/eliminate AMT
Strategy Overview
When you exercise an ISO, if there is a "bargain element" it may result in you owing AMT. Even though exercising an ISO doesn't generate regular taxable income, the amount of the bargain element is considered income for AMT purposes. Most individuals are able to realize some AMT income without it resulting in owing AMT tax but after a certain amount --> AMT taxes will be owed. For more info: 🔗Alternative Minimum Tax ("AMT)
One strategy to potentially reduce your AMT liability is to exercise your ISOs sooner, when the fair market value (as determined by a 409A valuation) is close to or the same as your ISO strike price. This minimizes the bargain element, which reduces the amount of AMT income realized from the transaction (and thus the possibility of owing AMT tax).
Tax Details
AMT is a parallel tax system to the standard tax system. Whether you know it or not, when you calculate your taxes, both (i) regular income tax, and (ii) AMT are calculated. You owe the higher of the two, so if your AMT liability is higher than your regular tax liability, you'll owe AMT.
ISOs are somewhat unique in that the bargain element per share is not considered income for standard tax calculations, but is considered income for AMT purposes. As such, a larger bargain element will result in a larger amount of AMT income per share when the ISO is exercised, increasing the likelihood that you will owe AMT tax.
To help optimize for AMT, one strategy is to exercise ISOs sooner vs. later, when the bargain element is lower (or $0). This will help minimize AMT and start the clock on favorable long-term capital gains tax treatment.
Exercising ISOs is foremost an investment decision. Tax optimization is important, but should be your secondary consideration.
Key Benefits
Minimize or eliminate AMT tax liability. Exercising ISOs earlier when the FMV is near (or the same as) the strike price of your ISOs minimizes (or eliminates) AMT income, and thus your potential AMT tax liability.
Start long-term capital gains holding period. Exercising ISOs starts the clock on your holding period for the shares. As a reminder, holding shares from ISOs at least 1 year after exercising is one of the two requirements to get favorable long-term capital gains tax treatment.
Key Considerations/Flags
Recoupable AMT credit. AMT tax is sometimes known as a "prepayment tax". If you pay AMT, you receive a credit for the incremental amount of tax you paid due to AMT. This credit is assessed for partial or full recoupment each tax year thereafter (based on specific tax/recoupment rules).
Uncertain future value. High-growth tech companies, especially those that are Pre-IPO, have significant risk. Optimizing for tax is important, but exercising options is foremost an investment decision (you could lose most, or all, of your investment).
Strategy: When to Consider This and When to Avoid It
🟢 When to Consider This Strategy:
You believe in the company's long-term viability and growth prospects. Exercising early makes sense if you think the stock value will continue increasing substantially.
You foresee a future liquidity event like an IPO or acquisition. Exercising earlier starts the long-term holding period and can result in more favorable tax treatment.
You have the available capital to pay the exercise cost (you must pay to exercise/purchase the shares, the cost of which may be significant).
You are comfortable with the risks involved. The stock value could decline after you exercise, including potentially losing 100% of your investment.
🔴 When to Not Use This Strategy:
You don't strongly believe in the company and its business prospects. In this case, exercising (i.e. investing in the company) is likely not a good risk/reward decision, even with the potential tax benefits.
Your risk tolerance is lower. Delaying exercise retains flexibility and reduces the capital at risk if the shares lose value.
You have limited funds available. Using cash to acquire shares now means you'll have less cash for other needs or investments.
Example
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