If you’ve worked in technology startup companies for even a short time, you’ve probably heard a story about or know someone who exercised stock options and got into trouble with alternative minimum tax (AMT). That story most likely involved incentive stock options (ISOs) and a drop in the company’s stock price after the person exercised their option.
While ISOs have potentially tax-saving features that non-qualified stock options don’t have, taxation of ISOs is more complicated and there are potential snags to be aware of.
ISOs and Regular Tax Rules
Under regular tax rules, when you exercise an incentive stock option, any gain in value resulting from an increase in stock price above strike price is not taxed. The gain in value becomes taxable when you sell the shares.
ISOs receive special tax treatment under the regular tax system if you meet holding-period requirements. If you hold your shares for two years from the date you received your stock option and one year after you exercised your option, then when you sell your shares any gain will be taxed at favorable long-term capital gain tax rates instead of higher ordinary income tax rates.
If you sell your exercised shares before the holding period, then you will not receive special tax treatment, and your sale will be taxed in one of three ways. If the sale price is less than the amount you paid for the shares (exercise price), you will have a capital loss. If the sale price is above the exercise price but less than the market price when you exercised, your gain will be taxed as ordinary income. If the sale price is above the market price when you exercised, your sale will be taxed in two parts: (1) The portion of gain per share equal to market price at exercise minus the exercise price will be taxed as ordinary income, and (2) the portion of gain per share equal to market price at sale less market price at exercise will be taxed as either short-term or long-term capital gain depending on how long you held the shares.
ISOs and AMT
The treatment of ISOs under the AMT system differs from treatment under the regular tax system and must be considered separately. First, a quick refresher on AMT:
The AMT system is a second tax system in addition to the regular tax system. On your federal tax return, you must calculate your tax owed under both systems and pay the higher amount. If your tax is higher under the AMT system, you report the extra AMT tax owed (above your regular tax) on your tax return as AMT. Most people refer to this as having to pay AMT. It is really the difference between the tax you owe under the AMT system and the regular tax system.
Under the AMT system, any gain in the value of your ISO shares is taxed when you exercise your option instead of when you later sell your shares as under the regular tax system. There are no tax costs under AMT rules when you first receive your option.
AMT tax treatment of your ISO shares further depends on when you sell them. If you sell your ISO shares within the year you exercised your option, the AMT tax treatment is the same as under the regular tax system as described above.
If you sell your ISO shares after the year you exercised your option, any gain is income under the AMT system. This is generally the case were you holding your shares to receive special long-term capital gains treatment under the regular tax system. Depending on your individual circumstances, this AMT tax treatment of your ISO shares can wipe out much of the regular tax savings from meeting the holding-period requirement.
The potential snag mentioned at the beginning of this article happens in this circumstance: If you exercise an ISO with the intent of holding your shares to get long-term capital gain treatment under the regular tax system, the gain becomes taxable under the AMT system on exercise. You will owe tax under the AMT system. If the stock price drops before you sell your shares, you still owe the same tax under AMT. The value of your stock holdings might even fall below the tax you owe under the AMT system as a result of exercising so that even if you sell the stock, you may not have enough money to pay the tax owed and you will have to use other assets to pay the tax.
One way to avoid the AMT snag is to sell enough shares to cover taxes when you exercise your option. Set those funds aside to pay the tax owed so you will have it even if the stock price declines after you exercise.
We also recommend running tax projections to determine whether exercising and meeting the holding-period requirement is beneficial in your situation. While the exercise-and-hold tax strategy for ISOs can lower your tax under the regular tax system, AMT tax treatment of ISOs offsets much of the reduction in many cases. Preparing tax projections under both the regular and AMT systems under various holding-period assumptions can help you determine whether the tax benefits to holding are worth the risk of a stock price drop.