Exercising Your Incentive Stock Options – Part II August 1, 2001February 20, 2017 But first, for those with no options but a TV . . . it’s Wednesday, and not too late for those of you who missed it earlier in the year to catch The West Wing re-run at 9pm on NBC . . . and then, after a suitable break to savor it and switch moods, Prime Time Glick on the Comedy Channel at 10:30. The thing to know about Jimminy Glick is that he is really Martin Short with about 100 pounds of make-up. If you have never heard of Martin Short, this may not mean much to you. But if you have, I think you will soon come to wish his talk show were nightly instead of weekly. And is it too early to start looking forward to Sunday? Malcolm in the Middle at 8:30pm on Fox is the best thing on commercial television, barring only The West Wing. And on HBO – which we finally broke down and started paying for 15 years after everyone else – there’s Sex in the City at 9pm followed by Six Feet Under. I have set the latter two in purple to indicate that they are on the racy side, and not for everyone. But they are terrific. [Note: As with any series you join in midstream, you really need to watch two episodes to give them a fair chance. I came this close to abandoning The Simpsons after a single episode (‘What are they saying? I can’t understand them!’), and shudder now to think what I would have been missing had I not come back for more. I still can’t understand much of what they’re saying on South Park, but for this I blame Canada.] Now, for those of you with no TV but incentive stock options . . . Beth Moursund: ‘Not all options work the same as your description in Tuesday’s column. I used to work at Microsoft, and had a very nice pile of options granted to me. Those particular options (and I don’t remember the particular IRS type-code) counted the difference between option price and current price as ‘ordinary income’ on the day exercised. Not short term gains — ordinary income, with Social Security and Medicare and all the rest of the taxes due without even getting AMT involved, whether you kept the stock or sold it. Anyone thinking about exercising options should check on the details and make sure they know which rules apply to the ones they have.’ ☞ Indeed. (See Michael Young, below.) Martin Fleisher: ‘What I advise clients to do about exercising ISOs is to do so as early in the year as possible, e.g., January 2. If the stock stays above the exercise price by the end of December, hold on to it and sell the following week when the 1-year holding period has passed. If the stock has declined below the exercise price, sell by 12/31 and no AMT.’ Andy Long: ‘I tell my students that there are only two times an option should ever be exercised: 1) When they are about to expire (assuming that they are in the money) or 2) Immediately before you plan to sell the stock. This has nothing to do with tax consequences, it is simply a matter of maximizing the underlying leverage of the option. There is no reason to give up the advantages of leverage until you are forced to.’ Michael Young: ‘Your write-up today on stock options really applies only to ISOs (*qualified* incentive stock options). Because of some of the qualifications and limitations, as well as corporate tax ramifications, many companies give out NQSOs (non-qualified stock options), instead of, or in addition to, ISOs. For example, IBM offers ISOs only to ‘executive level employees,’ but NQSOs to other people they want to retain. Even some startup companies have gone to issuing some NQSOs. ‘The tax treatment is quite different. When an NQSO is exercised, the difference between fair market value and strike price is immediately taxable as regular income. (On the bright side, there’s no AMT to worry about.) Not nearly as good as ISOs, but still better than no options at all. ‘As for paper millionaires stuck with AMT, they could always sell off some of their junk to generate some AMT loss (and get some cash to pay AMT on the rest of the gain). The AMT basis is the fair market price at exercise (the value used to compute the AMT gain). ‘The approach I recommend for ISOs that look like they’ll stay in the money is to exercise and hold as much as you can afford without running into AMT. Most people have a fair spread between their regular tax and AMT to work with. For me, the hassle to estimate the spread is worth it to get the long-term gains rate, but I recognize that many would balk at the complication. ‘But, one reason not to exercise until you’re ready to sell (which you may have implied but didn’t come right out and say): you don’t tie your money up. If you’re a startup founder, and your exercise price is a pittance, this isn’t a factor, but for most people, it can be.’