Please note the information below is intended to provide generalized information that is appropriate in certain situations.  It is not intended or written to be used, and it cannot be used by the receipient, for the purpose of avoiding federal tax penalties that may be imposed on any taxpayer.  The contents of the information provided below should not be acted upon without specific professional guidance.  Please call us if you have any questions.

Employees that receive stock options benefit from both the appreciation potential and lower capital gains. The tax planning objective would be to have most, or all of the profits taxed at a low capital gains rate and postpone taxes as long as possible.

There are generally two basic varieties of employee stock options:

-        - Incentive Stock Options

-        - Non-Qualified Stock Options

For this article we will be focused on the taxation of Incentive Stock Options (ISO). ISO are entitled to preferential tax treatment but are also subject to some special restrictions and unfavorable handling under the Alternative Minimum Tax (AMT) system.

For regular tax purposes, ISOs deliver two major league advantages (the not-so-favorable AMT situation

is explained later):

First, when the option is exercised, the excess of market value over exercise price (the bargain

element) goes untaxed at that time. 

Second, when ISO shares are sold, the entire profit (excess of sale price over exercise price) can

qualify for the reduced federal income tax rates on long-term capital gains. However, to qualify for

reduced rates, the date of sale for ISO shares must be

-        - more than two years after the option grant date (when the employee was given the option) and

-        - more than 12 months after the shares are purchased (by exercising the option).

If the preceding two holding-period rules are satisfied, the employee can achieve the twin goals of having the entire profit taxed at the lowest possible rate and delaying the tax bill until shares are sold and the employee has the cash to pay the tax.

Unfortunately, the bargain element on the exercise date counts as a positive adjustment for AMT purposes (positive for the Treasury, negative for the employee) in the year of exercise. The adjustment increases AMT income, which may cause the AMT to exceed the regular tax bill. If so, the taxpayer must pay the higher amount. In the event of an owing AMT, the taxpayer is entitled to an AMT credit. 

Our office can assist with preparing a tax forecast to determine how much you should exercise in order to avoid triggering AMT.   If you have any questions please do not hesitate to contact our office.