The first hurdle to clear to achieve tax free use of your incentive stock options is the treatment of the bargain element, which is the difference between the strike price and the fair market value of the stock on the day of exercise. For regular income tax purposes, the bargain element does not create income from simply exercising the options. For alternative minimum tax purposes, the bargain element counts as income. However, if the bargain element from the exercise is not too big, your tax calculation under alternative minimum tax may still be less than under the regular calculation. By spreading the options exercise dates over multiple years, it may be possible to keep the bargain element small enough in each year such to avoid incurring a liability from the alternative minimum tax. How much is “small enough” depends on the employee’s other income sources, marital status, and other factors.
The second hurdle to achieving tax-free treatment of your ISOs is that they must not be sold or transferred during the two-year period following the grant date and the one-year period after exercise. After you have purchased your shares by exercising the options, your investment could be lost if the stock price falls. This creates risk for this step of the strategy. If you need liquidity or do not have sufficient risk tolerance to hold the shares for at least one year after exercising the options, this strategy is likely not for you – at least not for all of your shares.
The final hurdle is a desire to give to charity. If the shares have been held long enough and are then donated to a qualifying charity, no capital gains tax is owed when the shares are donated. One great aspect of this is that the deduction for the donation will be calculated using the full market value of the shares at the time of the donation, not the price you paid for them. In contrast, if you sell the shares for a gain and then donate cash, you will likely owe capital gains tax on the gain.
As an example, suppose you have $100 of stock that was acquired for $10 more than one year ago and it has been at least 2 years after the grant date.
If you sold the stock, you would have a long-term capital gain of $90. Assuming a 15% federal capital gains rate and 9.3% California marginal income tax rate, this would create approximately $21.87 of additional income taxes ((100-10)*(0.15+0.093)).
In contrast, if you gave the stock directly to charity, you would have an itemized deduction for $100 and no capital gains tax. As long as you also successfully avoided AMT at the time of exercise, you would have successfully achieved tax-free utilization of your stock options. If you were going to give the $100 to charity anyway, this strategy would have effectively saved you $21.87 relative to selling the stock to donate the cash proceeds.
Your circumstances are unique. Not everyone itemizes deductions and the maximum bargain element before needing to pay alternative minimum tax varies by person. This strategy involves risk and is not for everyone, but we hope it will help you start a meaningful conversation with your tax professional.
If you have any questions regarding this article, or if we can help you with any concerns around stock options, investing, or financial planning in general, please give us a call at 925-300-3222.