I recently advised a client who had just received a promotion into a C-level role. As part of his executive compensation package, his company was offering him incentive stock options. He had been in an upper management position at the company in excess of 8 years and strongly believed in its future growth. He rightly viewed his incentive stock options as a major asset in his financial portfolio, but he was unsure how they would impact his tax situation.
Many C-level executives find themselves with questions about the most effective incentive stock options tax strategies. However, there’s a clear gap in the wealth management marketplace: very few financial advisors or tax professionals actually discuss how to strategically optimize equity compensation planning with their clients. As an executive wealth manager, one of my key roles as an advisor is to fill in the gap that exists around incentive stock options and how they are taxed. Together, let’s discuss how to maximize the benefits of your executive compensation stock options—and minimize your taxes owed.
How Are Incentive Stock Options Taxed?
Let’s start with the tax implications of equity compensation. If you are a salaried executive, you are likely used to your employer withholding an estimate of taxes owed from each paycheck before they compensate you. However, this will not be the case with your incentive stock compensation as there are no upfront tax implications.
When equity compensation is first granted, a vesting period—during which time you will not be eligible to exercise your stock options—is quite standard. For example, an employer might stipulate that you cannot exercise a stock option if you have been employed with them for less than a year. Once you exercise your stock option, however, you may trigger an alternative minimum tax for yourself.
What Is Alternative Minimum Tax?
The exercise of incentive stock options is not federally taxed. It is, however, used in the calculation of your alternative minimum tax. This is important to note because this can lead to greater tax implications than you may realize, a matter you will want to thoroughly discuss with your wealth manager or a tax professional.
According to the IRS, “Under the tax law, certain tax benefits can significantly reduce a taxpayer’s regular tax amount. The alternative minimum tax (AMT) applies to taxpayers with high economic income by setting a limit on those benefits. It helps to ensure that those taxpayers pay at least a minimum amount of tax.” In other words, the alternative minimum tax is a vehicle for the federal government to ensure wealthy individuals pay taxes by reducing or eliminating deductions and by including any additional revenue streams they receive as part of their total annual income.
Knowledge of the AMT is critical for recipients of equity compensation packages. If you exercise your stock option, and own the stock at the end of the year, that stock will be used when calculating your AMT. The amount of the AMT adjustment is equal to the difference between the fair market value when the stock was exercised and the strike price multiplied by the number of shares purchased. If you have a base salary on the lower end for executive salaries, but are compensated with incentive stock options, you could be in for a surprise come tax season—that is, if you haven’t worked with a seasoned executive financial advisor in regards to your equity compensation planning strategies.
What Are the Most Effective Stock Options Tax Strategies?
The most effective tax strategies for your incentive stock options, to be implemented with expert advice from your wealth manager, are:
- Sell your stock in a qualifying disposition
- Exercise your stock option near the beginning of the year
- Calculate your AMT and exercise just enough to avoid AMT taxes.
Tax Strategy #1: Sell Your Stock in a Qualifying Position
The first and most important step to financial planning around incentive stock options is to ensure that you are selling your stock in a qualifying disposition. This means that you have held the stock for at least two years since it was granted and at least one year since you exercised your stock option. If you follow these guidelines, with the help of an executive financial advisor, you will only be taxed at a long-term capital gains rate.
If, however, you sell your stock in a disqualifying disposition, you are subject to both ordinary income taxes and capital gains taxes. This can disrupt your well-intentioned tax planning, potentially requiring you to pay double the amount of taxes you would otherwise owe. To avoid this situation, work with an executive financial advisor who can ensure you meet the disposition guidelines set by the IRS when selling your incentive stock options.
Tax Strategy #2: Exercise Your Stock Option Near the Beginning of the Year
Another tax strategy to consider, with the help of your wealth management advisor, is exercising your incentive stock option near the beginning of the calendar year. This will allow you to monitor stock prices throughout most of the year, giving you a longer window to decide when to sell.
If you need to take a loss due to other taxable incidents, you can sell at a low or losing point. On the other hand, if you want to maximize your profit, you can attempt to sell at the apex of the market. While it is impossible to predict when or how much a stock will fluctuate, the more time you have to make your selling decision, the more opportunity you have to ensure that the sale meets your personal needs.
Tax Strategy #3: Calculate Your AMT and Exercise Just Enough to Avoid AMT Taxes
The last incentive stock option tax strategy is to meet with a tax professional to calculate roughly how close you will be to the AMT tax bracket. Part of this strategy will be determining exactly how many and how much of your stock options you should exercise in a given year to minimize or avoid the AMT classification.
If possible, your advisor can help you avoid the AMT entirely. However, due to high compensation levels, many executives find themselves subject to the alternative minimum tax. This makes it all the more important to properly plan ahead of time with your trusted tax professional, as well as an experienced wealth manager.
It can’t be said enough: in the wealth management industry there is a need to strategically plan for incentive stock options and their effect on your taxable income. You can maximize the financial benefits of your incentive stock options by educating yourself on the most effective tax strategies—and by working with an experienced executive financial advisor who can ensure that the bulk of your executive compensation stays in your estate.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for integrated asset allocation and equity compensation management. He has developed and utilized multiple tax strategies in relation to executive stock options. For more information on how Wade and the Carpenter Team can advise you on the most effective incentive stock options tax strategies, reach out today for a complimentary consultation.
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