Sell ISOs in the Same Tax Year to Avoid AMT
Selling ISO-acquired stock in the same tax year as you exercised avoids AMT. This can be a smart tax strategy in a few situations
Strategy Overview
Exercising ISOs frequently creates AMT income (and an associated AMT bill). However, if the ISOs are sold within the same year of exercise, the taxation changes: (i) the more favorable long-term capital gains tax treatment from a ISO qualifying disposition is lost (taxed as income instead), but (ii) the AMT impact is by and large negated if sold within the same tax year.
This creates a few strategic opportunities in certain circumstances. (1) It can be a wise tax move to sell ISOs in the same tax year if the price has declined materially after exercising. (2) Exercising ISOs and immediately selling can also make sense if an individual does not with to accept the investment risk associated with holding.
Tax Details
Exercising ISOs does not create/have a standard tax impact, but the bargain element is considered income for AMT tax impact purposes (see ISO Taxation for more details). If the ISOs have a large bargain element, the AMT tax impact can be substantial.
There are choices you can make with ISOs to avoid AMT --> mainly, selling ISO-exercised shares in the same tax year. Doing so triggers an ISO disqualifying disposition, which has less favorable tax treatment for standard taxation, but pretty much obviates any AMT impact. Strategically, there are a couple of circumstances where this is likely desirable from a risk and/or tax optimization standpoint:
No desire to take investment risk. Achieving an ISO qualifying disposition requires you hold the investment for at least 1 year after exercising. By definition, that requires holding the stock for at least 1 year and accepting the associated risk that the stock could decline in value (possibly materially). If your company is publicly traded, an alternative is to exercise and immediately sell the shares. Doing so creates an ISO disqualifying disposition, which has less favorable tax treatment, but you will have sold the position and have no single-company stock risk.
Minimize or avoid AMT if the stock price has declined (perhaps substantially) since you exercised the ISOs (in the same tax year). If you exercised an ISO with a large bargain element, and the price of the shares subsequently declined, there are circumstances where it is tax-favorable to sell the shares (triggering a disqualifying disposition) instead of holding them and achieving a qualifying disposition. For example (also see the image below), if you exercised ISOs with a strike of $11 when the stock was at $20, and later that year the price declined to $11, you have no capital gain. There is now no benefit to you from achieving a qualifying disposition --> and instead selling the shares (in the same tax year) will provide you with a more favorable tax outcome: avoiding an AMT bill and future AMT recoupment.
Note: this strategy frequently pairs with Exercising ISOs between January and April
Key Benefits
Ability to avoid AMT. Whether intentionally (i.e. exercise and immediately sell) to avoid investment risk, or due to a price decline, selling to trigger a disqualifying disposition in the same tax year you exercised will allow you to avoid dealing with AMT.
Potential tax savings. In the circumstance where the price has declined after you exercised ISOs, triggering a disqualifying disposition can many times actually be the financially optimal move due to save you from having to pay AMT, and then recoup it over many years --> especially due to the fact that if the shares have declined you will have dual tax basis and need to consider advanced strategies (i.e. Pair Capital Gains with AMT Capital Losses To Recoup AMT Tax Credit).
Key Considerations/Flags
If the shares have declined post-exercise, but still have a capital gain, the analysis is more complex. In a situation where shares have declined in value, but there are still tax benefits from holding and achieving an ISO qualifying disposition --> there are a mix of pros/cons between your choices (i.e. hold to qualifying disposition or sell in the same tax year to avoid AMT). Careful financial and tax modeling is encouraged to help you decide.
Hedging strategies for exercised ISOs may make sense in some situations (vs. exercise and immediately sell). In some circumstances, it may be tax/financially more optimal to exercise ISOs and use hedging strategies to manage the associated investment risk.
Strategy: When to Consider This and When to Avoid It
Uncomfortable with the investment risk. If you are uncomfortable taking the investment risk of holding the shares for a one year period, you should likely exercise and sell the shares. Your taxation will be less favorable, but you won't have any go-forward investment risk from the holding.
When the stock price has declined substantially after you exercised your ISOs (but still in the same year). In this situation--especially if you have a small or no capital gain--it is likely financially- and tax-optimal to sell versus hold.
Shares are flat or have modest declines. If the shares have declined some, but still substantial capital gains (current stock price minus the option strike price), the math likely still favors holding for a qualifying disposition (assuming you're still comfortable with the investment risk).
The stock price has declined substantially after you exercised your ISOs, but still has a significant capital gain. The pros/cons of selling versus holding in this situation depends on the numbers. Financial/tax modeling is encouraged to help you make the optimal decision.
Example
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