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Realize Tax Rewards On Incentive Stock Options

Now that the economy is showing signs of turning around, companies again may be inclined to grant incentive stock options (ISOs) to top-ranking officers and executives. If you’re in line for ISOs—or if you received them in the past—you can postpone tax due on any appreciation in your shares’ value until you sell the stock. What’s more, if you hold the stock long enough, your gain will be taxed at favorable capital gain rates. Still, there are pitfalls to avoid. In particular, you must navigate through a minefield of alternative minimum tax (AMT) rules.

Here’s the basic lay of the land: You can benefit from preferential tax treatment on ISOs (sometimes called qualified stock options) if you meet certain requirements. In contrast, nonqualified options (NQOs) are taxable at ordinary income rates as soon as you exercise them. NQOs are simpler, though, and they’re generally more favorable to the company, because it can deduct the value of NQOs. That’s not the case with ISOs.

To qualify as an ISO, an option’s exercise price must equal the stock’s fair market value at the time the option is granted. In other words, the company can’t provide an immediate discount as it might when issuing a NQO. Other ISO requirements include:

If you have ISOs meeting these requirements, you don’t owe any tax until you sell the stock. Moreover, capital gains will be considered long-term gains if: (1) You sell the stock more than two years after you received the option; and (2) you sell it more than 12 months after you exercised the option. The maximum tax rate on long-term capital gain is 15%, though the rate increases this to 20% for certain upper-income investors.

To see how this might work, suppose that on January 1, Year 1 you were granted an option to buy 100 shares of company stock at $10 a share. You exercised the option on July 1, Year 2, when the price was $15 a share. Then you sell the shares on October 1, Year 3, at $25 a share. Your taxable gain would be $1,500 (100 shares x the $15 appreciation over the option price). Because you sold the stock more than two years after you received the option and more than one year after you exercised it, the $1,500 gain is considered long term and you owe tax of just $225 (15% of $1,500) if you qualify for the 15% rate—even though you’re pocketing $2,500 (100 shares x $25/share). (This illustration is purely hypothetical and not indicative of any stock offering.)

What if you sold the stock at a price lower than the exercise price? You would realize a tax loss on the sale, because your basis is the exercise price. You could use the loss to offset capital gains and up to $3,000 of ordinary income this year. However, if the sale price was higher than the exercise price, but lower than the market value on the date you exercised the option, you would still have a taxable gain.

What about the AMT? Exercising an ISO is treated as an adjustment for AMT purposes, and so you may have to pay the AMT in the year you exercise an ISO, though some or all of the AMT liability may be eligible for use as a credit in future years. The stock’s basis for AMT purposes is equal to the amount paid plus the amount of the AMT adjustment. That may reduce any taxable gain when the stock is sold.

Of course, AMT liability will be affected by other variables in your personal situation, and any decision to exercise stock options and to sell the shares will be influenced by investment considerations as well as your potential tax liability. This is an extremely complex issue, so be sure to obtain professional assistance before you exercise an ISO.