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Renew an Existing Membership. Unlike non-qualified options NSOs , where the spread on an option is taxed on exercise at ordinary income tax rates, even if the shares are not yet sold, ISOs, if they meet the requirements, allow holders not to pay tax until the shares are sold and then to pay capital gains tax on the difference between the grant price and the sale price.
The AMT can end up taxing the ISO holder on the spread realized on exercise despite the usually favourable treatment for these awards.
Basic Rules for ISOs First, it's necessary to understand that there are two kinds of stock options, nonqualified options and incentive stock options. With either kind of option, the employee gets the right to buy stock at a price fixed today for a defined number of years into the future, usually When employees choose to buy the shares, they are said to "exercise" the option.
The company gets a corresponding tax deduction. This holds whether the employee keeps the shares or sells them. With an ISO, the employee pays no tax on exercise, and the company gets no deduction. Instead, if the employee holds the shares for two years after grant and one year after exercise, the employee only pays capital gains tax on the ultimate difference between the exercise and sale price.
If these conditions are not met, then the options are taxed like a non-qualified option. There are other requirementsfor ISOs as well, as detailed in this article on our site. But ISOs have a major disadvantage to the employee. The spread between the purchase and grant price is subject to the AMT. The AMT was enacted to prevent higher-income taxpayers from paying too little tax because they were able to take a variety of tax deductions or exclusions such as the spread on the exercise of an ISO.
It requires that taxpayers who may be subject to the tax calculate what they owe in two ways. First, they figure out how much tax they would owe using the normal tax rules. Then, they add back in to their taxable income certain deductions and exclusions they took when figuring their regular tax and, using this now higher number, calculate the AMT.
These "add-backs" are called "preference items" and the spread on an incentive stock option but not an NSO is one of these items. If the AMT is higher, the taxpayer pays that tax instead. One point most articles on this issue do not make clear is that if the amount paid under the AMT exceeds what would have been paid under normal tax rules that year, this AMT excess becomes a "minimum tax credit" MTC that can be applied in future years when normal taxes exceed the AMT amount. The AMT amount, however, becomes a potential tax credit that you can subtract from a future tax bill.
If in a subsequent year your regular tax exceeds your AMT, then you can apply the credit against the difference. How much you can claim depends on how much extra you paid by paying the AMT in a prior year. That provides a credit that can be used in future years. The amount you would claim would be the difference between the regular tax amount and the AMT calculation.
If the regular amount is greater, you can claim that as a credit, and carry forward any unused credits for future years. This explanation is, of course, the simplified version of a potentially complex matter. Anyone potentially subject to the AMT should use a tax advisor to make sure everything is done appropriately.
One way to deal with the AMT trap would be for the employee to sell some of the shares right away to generate enough cash to buy the options in the first place. So an employee would buy and sell enough shares to cover the purchase price, plus any taxes that would be due, then keeps the remaining shares as ISOs. For instance, an employee might buy 5, shares on which he or she has options and keep 5, But the employee will have more than enough cash left over to deal with this.
Another good strategy is to exercise incentive options early in the year. That's because the employee can avoid the AMT if shares are sold prior to the end of the calendar year in which the options are exercised. John holds on to the shares, but watches the price closely. John is a higher-income taxpayer. If, however, John sells before December 31, he can protect his gains. The rule here is that is the sale price is less than the fair market value at exercise but more than the grant price, then ordinary income tax is due on the spread.
On the other hand, if in December the stock price still looks strong, John can hold on for another month and qualify for capital gains treatment. By exercising early in the year, he has minimized the period after December 31 he must hold the shares before making a decision to sell. The later in the year he exercises, the greater the risk that in the following tax year the price of the stock will fall precipitously.
If John waits until after December 31 to sell his shares, but sells them before a one-year holding period is up, then things are really bleak. He is still subject to the AMT and has to pay ordinary income tax on the spread as well.
Fortunately, almost in every case, this will push his ordinary income tax above the AMT calculation and he won't have to pay taxes twice. Finally, if John has a lot of non-qualified options available, he could exercise a lot of those in a year in which he is also exercising his ISOs. This will raise the amount of ordinary income tax he pays and could push his total ordinary tax bill high enough so that it exceeds his AMT calculation.
That would mean he would have no AMT next year to pay. It is worth remembering that ISOs provide a tax benefit to employees who willingly take the risk of holding on to their shares. Sometimes this risk does not pan out for employees. Moreover, the real cost of the AMT is not the total amount paid on this tax but the amount by which it exceeds ordinary taxes. The real tragedy is not those who take a risk knowingly and lose, but those employees who hold onto their shares without really knowing the consequences, as the AMT is still something many employees know little or nothing about and are surprised too late to learn they have to pay.
Email this page Printer-friendly version. You might be interested in our publications on this topic area; see, for example: Global Stock Plans Discusses issues such as grant processes, transactions, and taxes for public companies that grant equity compensation outside the U. Performance Awards Discusses administration, financial reporting, and communication issues for public companies that grant performance awards.
Advanced Topics in Equity Compensation Accounting A selective and detailed examination of crucial issues in equity compensation accounting. Restricted Stock and Restricted Stock Units Discusses regulatory and administrative issues for public companies that grant restricted stock and restricted stock units.
Selected Issues in Equity Compensation A detailed look at some of the main topics in equity compensation. Liquidity Options for Entrepreneurial Companies Describes how entrepreneurial company owners can achieve liquidity without going public or selling the company.More...