Exercise ISOs Within 90 Days After You Leave a Company
To maintain preferential ISO tax treatment, departing employees should exercise their ISOs within 90 days (else they will convert to less favorable NSOs)
Strategy Overview
For employees leaving a company and owning vested ISOs, a key tax strategy is to ensure you exercise your ISOs within 90 days of departure. IRS rules specify that ISOs are only able to be granted to employees, and if an individual is not actively employed by a company for 91 or more days, then any/all ISOs shall automatically convert into NSOs. This is an IRS rule, and separate from any time constraint imposed by the company to exercise or forfeit vested options.
Tax Details
ISOs have preferential tax benefits relative to NSOs; primarily that if qualifying disposition criteria are met, all of the gains are taxed as long-term capital gains. Whereas with NSOs, the gains upon exercise are taxed as income. Due to these tax benefits, ISOs are preferential to NSOs in nearly all circumstances.
With the tax benefits of ISOs in mind, an individual with vested but unexercised ISOs has a key decision to make when they leave a company: exercise the vested ISOs shares within 90 days or allow the option to automatically become an NSO (per IRS rules, and excepting any company post-departure expirations).
Key Benefits
Maintain tax benefits of ISOs. By exercising your vested ISOs within 90 days of leaving your employer, you'll capture the tax advantages of ISOs (relative to NSOs).
Key Considerations/Flags
Significant investment risk exists. Exercising an option is first and foremost an investment decision. The potential future value of the stock may be significant if the company does well. However, there's also significant risk that the company may go bankrupt or never realize a liquidity event.
Post-termination exercise periods (PTEPs) can change the risk/reward. If your options have a built-in PTEP offering a favorable amount of time post-departure until vested options expire (e.g. 3-, 5-, 10-years), this can allow you to retain the upside potential of shares without requiring a cash outlay to purchase. Not exercising would mean your ISOs become NSOs, but the cash savings/non-investment-risk of not buying your vested units may be preferred.
Tax calculations can be complicated. The tax implications of exercising ISOs, especially when factoring in AMT, can be complex. It's often advisable to seek assistance from a tax professional or financial advisor.
Paying capital gains taxes at time of exit/liquidity event. When the company exits, and your shares are sold, you'll be liable for capital gains taxes. Planning for this eventuality is an important part of managing your ISOs.
Strategy: When to Consider This and When to Avoid It
High confidence in the company's business prospects. If you believe there's a good chance of a meaningful liquidity event or exit within the next few years, the potential upside could outweigh the risks.
Your ISOs have significant gains. If your unvested ISOs have significant gains, the tax benefits of exercising when they are ISOs (vs. converting to NSOs) are greater.
Lack of confidence in the company's prospects. If you're skeptical about the company's chances for a successful exit in the near future, the tax benefits likely do not outweigh the investment risk.
Financial burden. The cost of exercising your ISOs and potential taxes (AMT) can be significant. If these costs are more than you can afford or desire to pay/invest, you should rethink your strategy.
Example
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