ISO Bailout Strategy

Year-end disaster recovery

By Kaye A. Thomas
Posted November 29, 2007

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Sometimes a disqualifying disposition is desirable.

An essential part of the exercise and hold strategy for people with incentive stock options is a re-evaluation of that strategy before the end of the year to determine whether subsequent events call for a change in strategy. A decline in the stock price can produce a situation where the tax savings from a disqualifying disposition are greater than the tax savings from continuing to hold the shares.

Background

The main benefit provided by incentive stock options (ISOs) is the opportunity to convert the option profit from ordinary income to long-term capital gain. To achieve this benefit you have to hold shares for at least a year after exercising the option. The option holder is exposed to risk of a decline in the value of the shares, but the tax benefit can be rich enough to justify this risk, at least for some of the shares.

People using the exercise and hold strategy often have to pay alternative minimum tax (AMT). If you continue to hold shares as of the end of the year in which you exercise the option, the amount of AMT you pay is based on the value of the shares at the time you exercised the option. That's true even if the stock price is much lower at the end of the year, and even if you subsequently sell the shares at a much lower price.

Example: You exercised ISOs with a built-in profit of $1,000,000 and held all the shares. At the end of the year the shares have lost $800,000 of their value.

You still have $200,000 of profit built into these shares. If you don't sell them by December 31, though, your AMT will be based on the $1,000,000 paper profit that existed when you exercised the option. The tax is likely to be around $280,000 — in other words, the tax will be greater than your economic profit.

ISO bailout strategy

You can avoid paying AMT (at least, the part that results from the special tax treatment of ISOs) if you sell the shares before the end of the year. The result is a disqualifying disposition, which is normally an undesirable result when using the exercise and hold strategy because it eliminates the tax benefit of converting ordinary income to long-term capital gain. In this situation, however, selling the shares can produce overall tax savings.

The ISO bailout strategy is covered in Chapter 19 of Consider Your Options and Chapter 27 of Equity Compensation Strategies.

The reason is that ordinary income from the sale is based on your actual profit, not the larger amount that existed when you exercised the option. You're paying tax at a higher rate, but on a smaller amount of income. In the example above, a sale before the end of the year would result in $200,000 of ordinary income. At the top federal rate of 35%, the tax would be $70,000, or one-fourth the amount of AMT you would pay if you continued holding the shares.

To use this strategy, you need to sell the shares before the end of the year in which you exercised the option, and the sale has to be a transaction where you would be allowed to claim a deduction if you had a loss. That doesn't mean you need to actually have a loss, but the strategy fails if you have the type of transaction where a loss would not be allowed.

  • The transaction has to be a sale, not a gift or other transfer.
  • You can't sell the shares to a related "person" (which includes family members and also a business, trust or other entity owned by you or family members).
  • You can't purchase replacement shares within 30 days before or after the sale.

The reason for the last stipulation is that a purchase of replacement shares during that period would create the conditions for a wash sale. Even if you actually have a gain (as in the example, where the stock still shows a profit of $200,000), you lose the ability to limit your tax exposure if you buy replacement shares within the wash sale period.

The result of a failed bailout is particularly painful, because you have a disqualifying disposition without the income limitation. In the example, you would have to report $1,000,000 of ordinary income (not AMT). At the top rate of 35%, the tax would be $350,000 — so you end up in worse shape than if you continued holding the shares and paid AMT.

This opportunity to avoid a bad tax result is a key advantage of incentive stock options. You need to act by December 31, though — and advance planning is important if you're going to have purchases late this year or early next year that would create a wash sale condition.

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