With personal tax rates topping out at 37% on ordinary income for those in the highest tax bracket, and capital gains rates at 20% plus a 3.8% net investment income tax, you may feel like you don’t have much income left once your taxes are paid.
For those who’ve been granted incentives by their employers, such as stock options and restricted stock units (RSUs), it’s important to understand how your compensation plan is taxed and what you can do to reduce your tax liability.
You can’t make the taxes associated with your stock options go away entirely, but there are some strategies you can use to temper them. These strategies vary based on the type of grant you’ve received and, of course, your personal tax situation.
Types of Stock and Associated Taxes
In general, there are four federal taxes that impact employee stock grants.
Ordinary Income Tax
This is charged on basic earned income, including wages, consulting fees, interest income, ordinary dividends, and net rental income. The rate can range from 10% to 37%, depending on your tax bracket.
Capital Gains Tax
This tax is triggered by the sale of capital assets, and can apply to stock held in private or public companies. If you hold the stock for longer than one year, the sale will be subject to the preferential long-term capital gains treatment, which is 20% at the top tax bracket. Hold the stock for less than one year, and it’s considered a short-term gain and subject to your ordinary tax rate up to 37%.
Alternative Minimum Tax (AMT)
This tax mainly affects taxpayers with high incentive stock options (ISOs), and is calculated starting with a series of modifications to your taxable income—including adding back deductions such as for state tax, and incorporating spread income from the exercise of incentive stock options (ISOs).This results in a higher taxable income than these taxpayers are used to, which is then subject to the 28% AMT, (though it will normally generate a tax credit carryforward).
Each year you’re required to pay your regular tax or your AMT—whichever amount is higher—so exercising ISOs can create a tax liability even if you haven’t received any income. For this reason, AMT is often called a phantom tax.
Net Investment Income Tax
Taxpayers with income above certain thresholds--$ 200,000 for a single taxpayer—are subject to a 3.8% tax on passive income, including investment income. See our earlier Insight for more on this tax.
State & Local Taxes
Most methods of reducing tax exposure involve reducing the amount of stock income subject to ordinary income tax by making it subject to the long-term capital gains treatment instead—a potential tax improvement of about 17%. However, taxpayers will need to remain wary of the AMT, because exercising ISOs could have you paying more in AMT than in ordinary income tax, even at 37%.
Types of Employee Stock Grants
Reduce Your Tax Impact
There are a few ways you may be able to reduce the tax impact of your stock options and RSUs.
Exercise Early-Stage ISOs Before Their Value Increases
One tax strategy for taxpayers with ISOs is to exercise the stock options quickly, before there’s a spread in the grant price and the fair market value. On the one hand, you’ll be out the cash for the purchase of the options at a time when you can’t sell them yet. This is assuming your options are for a nonliquid stock. On the other hand, because there is no spread, you won’t need to be concerned about driving up your taxable income for purposes of the AMT calculation.
Though this is a simple strategy, many investors don’t act quickly enough to implement it. It’s especially useful if your ISOs represent less than 10% of your net worth and therefore aren’t particularly risky to you—or if the shares are truly inexpensive (pennies apiece). And by exercising your ISOs as soon as possible, you get the capital gains clock rolling, so you’ll sooner be able to sell at the preferential long-term capital gains tax rate.
Make the 83(b) Election for Early Exercise
Almost all stock option grants come with vesting restrictions—an amount of time that must elapse before you can take ownership of the stock. But many companies also offer the right to what’s known as early exercise. By electing early exercise, you accelerate the income tax consequences of exercising your stock, paying tax at the time of exercise rather than at vesting. As in the previous strategy, this starts the capital gains holding clock right away—but in this case, it’s before your stock options have even vested.
To pursue this strategy, you’ll need to file the Internal Revenue Code Section 83(b) election form within 30 days of purchasing your unvested options. Any spread between your exercise price and the value of the common stock will become taxable income at the time you file your election. Note that this strategy can’t be applied to RSUs.
Exercise ISOs to AMT Crossover Point
As you know, each year you pay the greater of your AMT or your ordinary tax rate. Many taxpayers’ ordinary tax rate is higher than their AMT in any given year, so in this strategy—assuming you haven’t exercised any ISOs already—you’d exercise ISOs only up to the point where you would enter AMT. This is referred to as the AMT crossover point, the point at which you’d begin to pay AMT on any additional ISO exercises. By purchasing stock only up to the crossover point, you’re essentially exercising them tax-free. But exercise any more, and you’ll end up paying the AMT phantom tax.
Raise Your Ordinary Income with Same-Day Sales
If you’re already in AMT and your stock is freely tradable, you may want to consider pursuing a same-day sale strategy. By exercising your options and then selling the stock immediately, you’ll raise your ordinary income such that your ordinary tax liability surpasses your AMT. You could go back and exercise more ISOs back up to the crossover point once you’re out of AMT and depending on how much additional leeway you’ve created for yourself.
Exercise ISOs Early in the Year
Not holding your ISOs long enough can trigger a disqualifying disposition that makes your gains taxable as ordinary income, but you can use this feature to your advantage. When you exercise an option, then sell it later in the year—triggering the disqualifying disposition—your income is computed by measuring the spread on the day of exercise; then a short-term capital gain or loss is incurred in the same year. You don’t have to pick up the AMT income from the day of exercise, because it’s been disqualified before year-end.
If your ISO is for a publicly traded stock, exercise early in the year and wait to see whether the stock price goes up or down by the end of the year. If it’s gone down, you sell. This triggers the disqualifying disposition and frees you from paying AMT on the spread when you exercised, which would be higher than the present spread. If the stock goes up, you continue to hold it, aiming for the long-term capital gains treatment.
To illustrate, say you exercise a portion of your ISOs on January 5. Your grant price is $1 per share, and the fair market value is $51 at the time you exercise. In the third quarter the company underperforms, and stock trades down to $31 a share. If you’re in AMT and you don’t sell the stock, you’ll pay the 28% AMT on a $50 spread despite the fact that the stock is now worth much less, generating a $14 tax liability. If you sell the stock instead, triggering the disqualifying disposition, you’ve generated $30 in ordinary income with a corresponding tax liability of only $8.40, assuming you’re still in AMT. Depending on how many ISOs you’ve exercised, the tax savings could quickly add up.
Take Deductions in Years with High RSU Vesting Income
Unlike the other employee stock grant types we’ve discussed, RSUs become taxable as ordinary income when they vest; they’re then freely tradable so long as you aren’t subject to insider lockup rules. The income from their vesting is reported on your pay stub, and the associated income and payroll taxes are automatically withheld. Regardless of whether you hold them or sell them, you’ve already paid income tax on the vesting of those shares. That part of RSUs is out of your control—but you can still reduce your overall tax bill with a little planning.
In years when large blocks of RSUs vest, your ordinary income tax will usually exceed your AMT due to the additional ordinary income. As long as that’s the case—you’re not in AMT—you can use state income tax and property tax deductions to reduce your ordinary income tax liability. If you’re likely to be in AMT next year, say, because you’ll have fewer RSUs vesting—you won’t benefit from any state income tax or property tax deductions taken then. You could wait to pay your state taxes until you file your return next April—but if you pay them by December 31, you’ll be able to deduct them from the current year’s taxable income, which means a reduction in your tax liability you won’t be able to take if you wait.
Note that timing your state and local tax deductions is now much less effective due to the $10,000 per year cap placed on such deductions under tax reform.
We’re Here to Help
Whether these strategies will be effective ways to reduce the tax impact of your stock options or RSUs will depend largely on your particular compensation package and your personal tax situation. To learn if one of these strategies or others may work for you and for help applying it effectively, contact your Moss Adams tax professional.
This updated article was originally published in July 2014.