What advantage would there be to exercising incentive stock options early?

I understand that for lowest US income taxes, you have to wait 2 years after excising to sell.

But two years now vs. two years later...does it make a difference?

It seems the later the better, as there is less risk.

  • Which type of exercise are you asking about? Cashless sell, cashless hold, cash purchase, or all of them? – shoover Nov 11 '17 at 1:24
  • Will your tax bracket be higher later than now? – chili555 Nov 11 '17 at 3:01
  • "It seems the later the better, as there is less risk." I don't follow. How does waiting to sell reduce risk? Once the conditions are such that you wish to sell, the longer you have to wait to sell, the more risk you take. – David Schwartz Nov 11 '17 at 3:55
  • @shoover, cash purchase, though I don't immediately see how that could change the answer. – Paul Draper Nov 11 '17 at 18:53
  • @chili555, good question. I suppose you've found a case where early exercise would help. – Paul Draper Nov 11 '17 at 18:54

You are thinking about it this way: "The longer I wait to exericse, the more knowledge and information I'll have, thus the more confidence I can have that I'll be able to sell at a profit, minimizing risk. If I exercise early and still have to wait, there may never be a chance I can sell at a profit, and I'll have lost the money I paid to exercise and any tax I had to pay when I exercised."

All of that is true. But if you exercise early:

  1. The fair market value of the stock will probably be lower, so you may pay less income tax when you exercise. (This depends on your tax situation. Currently, ISO exercises affect your AMT.)

  2. If the company goes through a phase where the value is unusually high, you'll be able to sell and still get the tax benefits because you exercised earlier.

  3. You avoid the nightmare scenario where you leave the company (voluntarily or not) and can't afford to exercise your options because of the tax implications.

In many realistic cases, exercising earlier means less risk.

Imagine if you're working at a company that is privately held and you expect to be there for another year or so. You are very optimistic about the company, but not sure when it will IPO or get acquired and that may be several years off. The fair market value of the stock is low now, but may be much higher in a year.

In this case, it makes a lot of sense to exercise now. The cost is low because the fair market value is low so it won't result in a huge tax bill. And then when you leave in a year, you won't have to choose between forfeiting your options or borrowing money to pay the much higher taxes due to exercise them then.

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  • "The fair market value of the stock will probably be lower, so you'll pay less income tax when you exercise." This question is about ISO, not NSO, for which AFAIK there is no tax incentive until you sell. – Paul Draper Nov 12 '17 at 19:49
  • @PaulDraper Like all complicated tax issues, it depends. For example, exercising an ISO does affect your AMT. I updated to clarify. – David Schwartz Nov 12 '17 at 20:58

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