If I have a fixed amount to invest, should I exercise and hold NSOs or ISOs of my company?

Question

I am trying to play some scenarios to compare opportunity costs and hopefully decide on which route, to maximize my gains (after all taxations).

I formulated a spreadsheet to help me calculate a few things but it looks like I may be better off with NSOs than ISOs. Intuitively that doesn't make sense. I'd like some scenarios and pointers on how I could go about this evaluation.

Question: If I have a fixed amount to play with (say $3000) then should I exercise in NSOs or ISOs?

Scenario: Strike price of NSOs and ISOs = $3 FMV = $5 Projected FMV in a month or so (409A coming up) let's assume is going to be $7 Assumption also that the stock continues to rise. So let's say a longer term value of $12

It looks like I won't hit AMT for this small amount (I haven't hit it previously and ran some numbers by a tax advisor).

I fully understand the benefit of exercising as early as possible for leveraging Long Term Capital Gain Tax. Where would I benefit by investing the $3000 more?

My calculations:

1 - ISO - I'll get 1000 stocks and won't trigger AMT. Then selling it at $12 a piece would be $12000. After tax (approx 20%), I'll get $9600

2 - NSO - Budgeting for the withholding ($2 (FMV - Strike) * 750 NSOs) = $1500 reported income. So at ~ 40% tax I'll have to cover $600 for withholding. So $600 + 3*750 = $2850. So I can only exercise about 750 NSOs. I'll hold it for more than a year and eventually with the same $12 sale price, proceeds = $9000. At LTCG I'll pay ($12-$5)7500.2 = $1050 in tax + the withheld $600 = $1650 in total tax. Effective gain = 9600 - 1650 = $7950.

I am not sure if this was a correct way to do the assessment but I am beginning to get confused. Any hints?

I have more options (NSOs and ISOs) than I can buy right now. So my other thought is whatever I buy now, will leave the other set for a same day sale eventually (in a liquidation event). So I want to account for the taxes at that time too on the ones I leave un-exercised.

California, United States, Married filing jointly

Answer 1

I have, since asking the question, made some decisions and so I will answer my question with my experience.

Given that same day sale of ISO and NSO is treated alike, i.e. Ordinary income tax, if exercising is not done, then at the long term value of the stock you should expect to pay tax at your highest tax bracket for any gain.

Decisions on whether to exercise ISO or NSO can be made based on the following indicators:

1. Are you about to hit AMT limit? (Have a tax advisor work with you on this.) If not, then you should do ISOs first because you don't incur any tax.
2. If you are about to hit AMT, chances are you already exercised a lot of ISOs (or at least enough ISOs where Fair Market Value (FMV) is more than the strike price). Do you have money to cover taxes in advance?
3. If yes, then be prepared to pay taxes upfront and buy NSOs. The taxes you will pay will be ordinary income tax on ((FMV - strike price) x num stocks) but if you expect the stock to go much higher eventually, you could get a better tax treatment on that much higher gain in stock price.
4. If you are at a point where you don't have enough money to cover taxes but also are unwilling to buy lesser number of NSOs then just wait it out.

ISOs are better than NSOs because you don't have to prepay taxes but mind the AMT trigger point. It is possible that your regular tax may be lower under certain other circumstances like stock market loss on public stocks, loss from home sale, etc. This is why a tax advisor is essential to make that decision.

Answer 2

It is worth noting that, unless you particularly believe in it, investing in your own company means that your investment and your job are at the same risk; investing elsewhere means that if the company has hard times and let's people go your investments are less likely to move in the same direction.

In the other hand companies really like to see employees buy their own stock, as they feel it makes the employee more invested (literally and emotionally) in the company's success. That's a major reason larger companies often off Employee Stock Purchase Programs that let workers buy company stock at a discount from current trading price.