Why were my taxes so low for cashless exercise of ISOs?

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Topic Author
mjm21
Posts: 15
Joined: Mon Dec 25, 2017 6:46 pm

Why were my taxes so low for cashless exercise of ISOs?

Post by mjm21 »

In September 2020, I entered into a 10b5-1 plan to sell a bunch of shares from 2 different stock plans that were ISOs. It was a cashless exercise (which I believe is another term for sell-to-cover, because that’s essentially what it was). The shares were sold in January 2021.

I looked at the statement from the brokerage company versus what I saw in my bank account, and my ISOs were only taxed at 8.4% (for a disqualifying disposition). In other words, I got 91.6% of the profits into my bank account. This is unusual because I also sold NSOs in the 10b5-1 plan, and the NSOs were taxed at about 40%.

I went through an accountant recently to pay estimated taxes on my long-term capital gains ISOs that I sold in January 2021, and the shares were taxed at 15% for both federal and state, so it was a total of a 30% tax.

Why was I taxed so little for the cashless exercise ISOs? Are taxes sometimes very low when you do a cashless exercise, and when it comes time for your tax return, the IRS finds out that you underpaid, an then you owe more taxes? This would still be strange considering the fact that I was taxed at 40% for my NSOs.

Also, what tax rate should I have been taxed at, or what tax rate will I be taxed at when it comes time to file my tax return? I know it’s probably impossible to tell based on how little information I gave, but what would you estimate for a salary range for 50-100k?

Thanks for the help.
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gobel
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Re: Why were my taxes so low for cashless exercise of ISOs?

Post by gobel »

There is no tax withholding on ISO exercises. There is also no payroll tax on them. The opposite is true for NSOs. To get to 40% on the NSO exercise, some of the withholding was to the IRS, some to the state, and maybe some to FICA. I used to get a statement upon each exercise that listed the breakdown.

I don't know why even 8.4% was withheld from your ISO exercise. Are you in Pennsylvania? That is the only state that I know of that has to withhold for state taxes (but even that is not at 8.4%). (You are calculating based on *profit*, right? not sale price)

I also don't know why your CPA estimated taxes on the third sale at 15% for state. That seems high, if it's only to pay for that sale.

In the end, these are just prepayments on taxes and all the profits from these sales will show up on your tax return to calculate the actual amount. The same-day-sale of the ISO and NSO will be taxed at your marginal income bracket. The LTCG that you sold will probably trigger 15% federal tax, possibly 3.8% NIIT, plus state taxes.

You should use some tax software or website to estimate your total taxes, then make sure your withholding from your paycheck meets the "safe harbor" threshold (ie that you have withheld 100% or 110% of last year's taxes). If you do that, there will be no penalty, even if you have to write a big check when you file.
Topic Author
mjm21
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Joined: Mon Dec 25, 2017 6:46 pm

Re: Why were my taxes so low for cashless exercise of ISOs?

Post by mjm21 »

gobel wrote: Thu Sep 16, 2021 5:18 pm There is no tax withholding on ISO exercises. There is also no payroll tax on them. The opposite is true for NSOs. To get to 40% on the NSO exercise, some of the withholding was to the IRS, some to the state, and maybe some to FICA. I used to get a statement upon each exercise that listed the breakdown.

I don't know why even 8.4% was withheld from your ISO exercise. Are you in Pennsylvania? That is the only state that I know of that has to withhold for state taxes (but even that is not at 8.4%). (You are calculating based on *profit*, right? not sale price)

I also don't know why your CPA estimated taxes on the third sale at 15% for state. That seems high, if it's only to pay for that sale.

In the end, these are just prepayments on taxes and all the profits from these sales will show up on your tax return to calculate the actual amount. The same-day-sale of the ISO and NSO will be taxed at your marginal income bracket. The LTCG that you sold will probably trigger 15% federal tax, possibly 3.8% NIIT, plus state taxes.

You should use some tax software or website to estimate your total taxes, then make sure your withholding from your paycheck meets the "safe harbor" threshold (ie that you have withheld 100% or 110% of last year's taxes). If you do that, there will be no penalty, even if you have to write a big check when you file.
I just looked at the statement from the brokage company again, and you’re right; no tax was withheld from the ISOs with disqualifying dispositions. The money transferred to my account was less than the profit because of the cost basis.

I looked at my 2020 tax return, and for federal tax payments, it says $9473 for total payments, and $9514 for total tax. For state tax payments, it says $3918 for total payments, and $3533 for total tax.

My accountant recently scheduled a payment to the IRS for $5500 and to the state for $5500. For the long-term capital gains sale in January, the profit was $36k. The payments to the IRS for estimated taxes were based on the long-term capital gains stock sale.

For the disqualifying disposition ISO stock sale in January (the cashless exercise), the profits were $38k total for the 2 different stock plan shares combined. There were also three more times throughout the year that I sold stock for the disqualifying disposition ISOs, but each time it was about a $5k profit, for a total of about $15k in profits throughout the year.

Did I underpay for the estimated taxes for this year? Do I actually have to pay more in estimated taxes this year because of the disqualifying disposition ISOs, otherwise I will get a penalty? You mentioned withholding 100-110% of last year’s taxes, but $5500 is under the federal taxes that I paid last year.

Or will I not have a problem with estimated taxes and I won’t have a penalty next year?

Thanks.
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gobel
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Re: Why were my taxes so low for cashless exercise of ISOs?

Post by gobel »

My guess is you are ok, because of the NSO sale and the extra withholding it caused. Ie assuming your regular pay has not gone down, the withholding from your salary + the NSO withholding will be more than 100% of what you owed last year ($9514 and $3533), which qualifies as "safe harbor" and avoids underwithholding penalties.

But to double check, look at your last paycheck stub and the YTD totals for fed and state withholding. Then add the expected amount for the rest of the year (8 more paychecks or whatever). If it is too low, or you just want to be extra safe, you can update your W-4 to withhold more each paycheck.

Even if you are avoiding the penalties, you should make an estimate of your tax now so it's not a surprise next year. With 38k +15k + 36k already, and maybe some other stuff, you will owe 10-20k across state and federal at tax time.
Topic Author
mjm21
Posts: 15
Joined: Mon Dec 25, 2017 6:46 pm

Re: Why were my taxes so low for cashless exercise of ISOs?

Post by mjm21 »

gobel wrote: Thu Sep 16, 2021 8:35 pm My guess is you are ok, because of the NSO sale and the extra withholding it caused. Ie assuming your regular pay has not gone down, the withholding from your salary + the NSO withholding will be more than 100% of what you owed last year ($9514 and $3533), which qualifies as "safe harbor" and avoids underwithholding penalties.

But to double check, look at your last paycheck stub and the YTD totals for fed and state withholding. Then add the expected amount for the rest of the year (8 more paychecks or whatever). If it is too low, or you just want to be extra safe, you can update your W-4 to withhold more each paycheck.

Even if you are avoiding the penalties, you should make an estimate of your tax now so it's not a surprise next year. With 38k +15k + 36k already, and maybe some other stuff, you will owe 10-20k across state and federal at tax time.
I just have one more thing that I wanted to ask.

When tax season comes, will the brokerage firm that handles my stocks send me a tax form stating all the information I need to file my taxes (similar to how a company sends me my W2 during tax season)? My company is changing the current brokerage firm to E-Trade and transferring the 10b5-1 plans over to Morgan Stanley. I believe E-Trade is a subsidiary of Morgan Stanley. Or will it be up to me to determine all the necessary information to file my taxes? I will be using an accountant next year instead of turbotax, so I want to hand over all the information to my accountant.

Thanks.
crefwatch
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Re: Why were my taxes so low for cashless exercise of ISOs?

Post by crefwatch »

The tricky reporting part is the adjustment of the basis for the shares sold. 20 years ago, Fidelity only sent a straightforward (I.e. wrong) 1099 that made the cashless exercise look like all STCG money based solely on the gross sale price. More recently, the last page of the 1099 has had an alternate calculation that takes the grant price into consideration. Your brokerage may vary. Your accountant can adjust the basis if necessary, himself. I had to point out to our accountant that this is Ordinary Income.
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