Incentive Stock Option (ISO) tax question

Question

Here's the scenario:
I live and work in New York City.
On November 1, 2017 I get granted 80,000 ISO's that vest over four years (with a one year cliff). The strike price is $3.
On November 1, 2018 I've vested 20,000 of the options. Again, my strike price is $3. The fair market value (FMV) has grown from $3 to being $5 now.
Instead of paying cash out of pocket to exercise my vested options, I opt to utilize the following clause in the option agreement:

Payment of the Exercise Price can be done by surrendering of other Shares which (i) shall be valued at its Fair Market Value on the date of exercise, and (ii) must be owned free and clear of any liens, claims, encumbrances or security interests, if accepting such Shares, in the sole discretion of the Administrator, shall not result in any adverse accounting consequences to the Company.

Questions:

What is the maximum number of shares I can own without spending any cash out of pocket?

What will my tax liability be?

Hilmar · Answer

You do a "same day" exercise of 12000 shares. That nets your $24000. 
With the $24000 you can exercise the remaining 8000 shares.

Alternatively you could exercise 12000 shares for $36000 and immediately sell 7200 shares to recover your exercise price. Then you use the remaining 4800 share to pay the exercise price of the remaining 8000 options. Both scenarios are equivalent but may have different fees associated, so it's worth checking the fine print.

Tax wise:

The first transaction generates $24,000 of compensation income for
both regular tax and AMT
The second transaction is not taxable for regular tax but generates another $16000 of compensation income for AMT.

The above example is "cash neutral before taxes". The taxes associated with these transaction are substantial, so it's highly recommended to talk with a tax adviser. "cash neutral after taxes" depends highly on your specific tax situation.

Michael · Answer

I've bought ISO stock over the years — in NYSE traded companies.  Every time I've done so, they've done what's called "sell-to-cover".  And the government treats the difference between FMV and purchase price as if it's part of your salary.  And for me, they've sold some extra stock to pay estimated taxes.
So, if I got this right...  20,000 shares at $3 costs you 60,000 to buy them.  In my sell-to-cover at 5 scenario:

you'll owe taxes on 20,000 shares * (5-3 per share) = 40,000.  Assuming your marginal tax rate between city, state and federal is 50%, that comes out to be 20k.  note I chose 50% for ease; almost certainly your combined marginal is different.
So 20k/5 — they'll sell 4,000 shares to pay the taxes I guessed at.
60k/5 — they'll sell 12,000 shares to pay for the shares you get to keep.
you get to keep 4,000 shares.

Did I get that right?  Keeping only 4,000 shares out of 20,000 doesn't feel right.  Maybe because I've always sold at a much higher ratio between strike price and FMV.
Note I made some assumptions:  first is that the company will sell some of the stock to pay the taxes for you.  Second is your marginal tax rate.  Before you do anything check these.
Is there some reason to exercise immediately?  I'd wait, personally.

Incentive Stock Option (ISO) tax question

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