Taxes are never a fun, or funny, topic but when you can demonstrate how much you can defer and ultimately reduce in taxes when you avoid the premature exercise, it may bring tears to your eyes if you learned this too late, especially since alternatives do exist in the form of hedging.

Tax Liabilities for ESOs

The biggest downside of premature exercise is the big tax event it induces, along with the lost time value. You are taxed at ordinary rates on the intrinsic value gain (the spread between strike price and stock price, if options are above water) and that tax can be as high as 40%. Worse, it is all due the same tax year and paid upon exercise. If you have capital losses elsewhere in your portfolio, furthermore, you can apply only up to $3,000 per year of these losses against these compensation gains as an offset of the tax liability. So, it is hard to reduce the liability much once the premature exercise is done. And once it is done, it cannot be undone. (Make the most of your tax return; read Give Your Taxes Some Credit .)

Now that you have acquired stock that presumably has appreciated in value (spread between stock price and exercise price), you are faced with the choice of either liquidating or holding. Here, it can get even more risky. Maybe you exercised and planned to liquidate. In that case, assuming you dont have a change in the price of the stock from date of the exercise, there is no change in outcome. You have your after tax-gains locked in and you can do what you would like with them.

But if you hold the stock, or part of it, and then you liquidate with any gains (above the stock price upon exercise day, (which is now your basis price), you may incur additional tax liabilities in the form of short-term capital gains. They are owed in the same year you paid the compensation tax. You have to hold the shares for longer than one year and one day from the date of exercise to get the lower, long-term capital gains rates. Therefore, you may end up paying two taxes compensation and capital gains. So, generally speaking, once an exercise is done, any gains in that tax year are taxed at the short-term capital gains rate. If you have to prematurely exercise, it is smart to diversify your gains into other assets, preferably assets that are not correlated, to avoid capital losses, which are not going to help much in terms of offsets.

An Example

For example, another scenario is worth considering here that many ESO holders may unfortunately find themselves facing. Lets say you have ESOs giving you the right to buy 1,000 shares of XYZ stock at $50 and the stock is trading at $75 with five more years until expiration. You are worried about stock market prospects and you decide to exercise your ESOs to lock in the $25 per share profit (intrinsic) on the ESOs. When you give the premature exercise notice and get the stock at $50, you decide to leave some (half of the stock) on the table to hedge your bets for more upside gains. Meanwhile, you put your stock sale proceeds (from the other half) in CDs. (Do CDs deliver in any market? Read Are CDs Good Protection For The Bear Market to find out.)

Suppose you sold 500 shares at $75 for a $12,500 gain following your full exercise ($75 $50 = $25 x 1,000 = $25,000). In this case, you would net after-tax gains of $2,500 (remember, you paid compensation tax on the intrinsic for the full 1,000 shares, even if you sell only 500). Meanwhile, you are holding 500 shares bought at $50 still, with a basis at $75, with $12,500 in unrealized gains (but tax paid for). But then, lets say you subsequently experience a drop in the stock price back to $50 from $75 before the end of the year. The second unsold position has now lost (or given back) $25 per share, or $12,500, since you acquired the shares through exercise (that lost value was already taxed as well). Now you have lost $12,500, and if you liquidate, you can only declare these losses as capital gains losses up to $3,000 in that same tax year, with the rest applicable across future tax years up to $3,000 per year.

Therefore, taken together with tax implications, you have paid $10,000 in compensation taxes on the full exercise, locked in $2,500 in after-tax gains through the sale of 500 shares after exercise, and made nothing on the second half of the 1,000 shares (yet have losses of $12,500, up to $3,000 of which you can write off that year and subsequent years). To recap, you realized $12,500 with the sale of 500 shares, paid $10,000 in compensation tax on $25,000 exercise gain, made nothing on the second 500 shares as price went back to $50, but have $3,000 you can use as tax offset.

So, because you hedged by liquidating half, you kept your after tax gains to $5,500. But this does not count lost time value from the early exercise, which presumably would be about one-third of the initial fair value of the options, perhaps as much as $10,000. Furthermore, you no longer have potential to gain from upside movement in the stock. Had you held you position a worst-case scenario you would have paid $10,000 in tax on exercise and been left with your compensation, revealing just how important tax issues are to ESO holders.

Unexpected Fees

Other issues with early or premature exercise involve coming up with the money to make the exercise and acquire the stock (and pay the tax). As we saw above, this can be quite high (you need to pay the $50,000 exercise plus $10,000 in tax to acquire the stock). Sometimes, however, employers will arrange for a cashless exercise, whereby a broker will front the money to allow for the exercise. But here, you still have withholding removed once the exercise occurs. The income (intrinsic value) is taxed as ordinary income. (Find the hidden fees in your portfolio to increase your rate of return in The Hidden Costs Of Investing .)

While there are other scenarios that can be explored, the point here is to demonstrate how tax events (of two types compensation and capital gains/losses can be quite burdensome and mismatched. Therefore, any decisions should be made with the aide of professional accounting help.