Volume 12 Issue 4 -- July/August 2000
In the last issue (click here), we looked at so-called Non-Statutory or Non-Qualified Stock Options (NSSOs). This time, we will look at Incentive Stock Options, usually referred to as ISOs. Next time, we will look at a number of planning issues relating to stock options.
ISO plans have two potentially important tax advantages to employees. First, the exercise of the ISO option usually does not trigger any recognition of income or gain, even if the stock is unrestricted.
Second, if the stock is held until at least one year after the date of exercise (or two years from the date the option is granted, whichever is later), all of the gain on the sale of the stock, when recognized for income tax purposes, will be capital gain, rather than ordinary income. If the ISO stock is sold prior to the expiration of that holding period, then the income is ordinary income.
For example, suppose that Zed, an employee of BigDeal.com, is granted the option to purchase BigDeal.com stock at a price of $45 per share. One year later, when BigDeal.com stock is trading at $100 a share, Zed exercises his option and then holds the stock for two years, at which point he sells it at $200 a share.
Under the ISO rules, the exercise of the option would not be subject to tax as compensation income, and all $155 per share of gain would be capital gain when he sold the stock.
As is true with many tax "benefits," these come at a price. In this instance, the price is exacted by the dreaded Alternative Minimum Tax (AMT).
While the exercise of an ISO does not cause any taxable event under the regular tax system, it does have consequences under the AMT system. Under the AMT rules, the difference between the fair market value of the stock and the option exercise price will be treated as taxable income when the employee’s rights to the stock become fully vested and no longer subject to a risk of forfeiture. This "spread" is treated as an AMT adjustment.
In Zed’s case, while the exercise of the option would not trigger recognition of regular income tax, it would result in the creation of an AMT adjustment in the amount of $55 per share. The effect of this AMT adjustment can be to require Zed to recognize AMT taxable income, and perhaps pay AMT tax, on his exercise of the option, even though the stock might be held for many years or ultimately sold at a loss.
Also, the basis in the stock, for AMT purposes only, becomes in effect the fair market value as of the date that the AMT adjustment arises. In theory, because of this basis adjustment, when the stock is actually sold, there will be no AMT gain to the extent of the "spread" that was previously subject to AMT tax.
Because the basis in the stock for regular tax purposes will not include the "spread" that was previously included in the AMT taxable income, there is a risk of double taxation.
In theory, the payment of AMT in the year of exercise creates a credit which then reduces the regular tax in the year the stock is actually sold, since in that year, disregarding all other factors, the regular taxable income would be larger than the AMT taxable income, owing to the differences in the stock basis.
This is, at least, the theory, in greatly simplified form. In practice, however, the extent to which there will be a significant risk of double taxation depends upon the rather complicated calculation and operation of the AMT credit.
While the rules for the two different types of stock options differ, both ISOs and non-qualified options afford employees the opportunity to convert what would otherwise be ordinary, compensation income into capital gain. Given the current capital gain rates, that advantage can be significant. Taking full advantage of this benefit, however, can require careful planning at the time of both the exercise and the subsequent sale of the stock, and this is particularly true with planning for the AMT consequences of ISO stock. Next time, we will consider a few of the more common planning problems. For a more detailed analysis of stock options, click here.
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