Tax-efficient Exit Strategies For ISOs After an IPO

Incentive Stock Options, also abbreviated as ISOs, are those stocks that are usually provided to employees as part of their compensation package. An IPO can be quite rewarding; however, dealing with tax implications is deemed of crucial significance during the times when you’re about to sell your ISOs. 

To help you combat stress and tax complexities, we’ve gathered all the necessary information that we can with regards to ISOs. Let us have a look at it together:

What is an ISO, and What are its Potential Tax Benefits?

ISO is solely for an employee of the company. ISO can be understood as an investment stock that an employee can purchase at an exercise amount that is comparably lower than the fair market value, or FMV. There is no particular advantage to these stocks unless you plan to sell them, and when you plan to do so, here is what you’ll be relieved of:

• Exercise: 

To acquire the shares, you will have to pay the amount.

• Holding period: 

Approximately, after exercising, you will have to keep these ISOs for a period of one year. After completing this holding period, you can ultimately sell these and become eligible to receive favorable tax treatment from the legislation.

• Tax on Spread: 

There is a great difference between the sale price and the price at which you purchased these shares (exercise amount). And the profit you earned is considered capital gain, which has the following tax benefits:

• Ordinary Income Tax: As much as per your marginal tax bracket, ordinary income tax will be applied if you sell these stocks within holding period. 
• Capital Gains Tax: As per the announced updated rates, capital gains tax is lower than ordinary income tax and will be applied after you have completed tiem tiem frame of your holding period. 

Tax Efficient Exit Strategies:

Since you have now understood all the basics of ISOs, now its time to shed some light on these tax benefits:

Requirement 1: You must ensure that you have completed the time frame mentioned in your holding period, i.e., one year. Having said that, plan your sales accordingly to minimize paying ordinary income tax and get yourself some tax benefits. 

Requirement 2: Decision – Whether to Exercise Before or After IPO?: You must take this decision very seriously as it will be a turning point for you in terms of :

• Exercise Before IPO

If you decide to exercise before IPO, here is a list of benefits you can avail: 

• Lower exercise price is locked which is also defined as pre-IPO valuation.
• Intelligently, right before IPO ticking starts, begin your one-year holding period. This will eventually reduce your waiting time to sell ISOs and gain favorable capital gains.

With the benefits, there comes a list of drawback that you must be aware of:

• Usually, if you decide you exercise before IPO, you will need upfront cash, which is not possible and ideal for everyone. 
• Since this act of yours will be considered as betting, there are possibilities that the company stock pricces might go down after going public. 

• Exercise After IPO:

If you decide to exercise after IPO, here is of benefits that you will most likely avail:

• No need for an upfront cash.
• Since you’re well aware of the the stock prices, you will have greater certainty about the forecasted stock prices once teh company goes public. 

With the benefits, there comes a list of drawback that you must be aware of:

• The pre-IPO price might be greater than the exercise price, hence your potential gains may be reduced.
• After you exercise, your holding period will begin and you might not be able to sell it for capital gains unless you complete one year holding period, 

Whichever strategy you most likely adopt, depends upon your personal circumstances, such as financial achievements and risk tolerance. Moreover, you can also consult a tax advisor like Dimovtax.com, who can help you make a significant decision considering employee stock options and market trends. 

• Investment Diversification

ISOs have been identified as a vital wealth source; however, it is recommended to diversify your investment patterns to minimize potential losses. 

• Tax-Advantaged Accounts:  If you own a tax advantaged account, what’s better than selling some of your ISO shares within 401(k) or IRA? Once you choose to sell them, your gains will eventually grow to be tax-deferred or tax-free depending on which account type you own. 

Bottom Line:

There is no doubt you can gain significant wealth while exercising and selling ISOs after an IPO. but it is necessary to understand the necessary tax implications and accordingly implement tax efficient exit strategies. If you are unaware of these, you must seek assistance from tax experts like Dimovtax.com and enjoy yourself a bigger slice of the pie.