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From:   GB

...I have written to several online sources seeking information, including the IRS, and have not gotten a clear answer. (Although the IRS answer was the longest, it was on the wrong subject). My question involves ISOs and AMT.

This is my understanding:

1. Exercising an ISO and converting into stock and holding through the appropriate holding periods does not generate ordinary income, but is applicable to the AMT calculation.
2. When you sell the stock (after 12 months) you will pay capital gains tax on the difference between the original option price and the selling price minus certain costs of purchasing.
3. Any AMT paid can only be used to reduce future tax, but does not change the basis of the stock.

My question is what are the real advantages of ISOs vs non-qualified options? If I exercise an ISO I will windup having to raise additional cash to pay the AMT and it is not clear how long it will take me, if ever, to recover the credits from the AMT. It seems like you get taxed twice for exercising ISOs. Can you show me examples with real numbers, outlining the assumptions used, that will help me understand.

Thanks,

GB

Answer

Hello GB,

Here is an example of an ISO transaction compared to a Non-Qualified Stock Option transaction.

Assumptions

• Single
• One exemption
• Wages $100,000
• Residential Mortgage $10,000
• Real Estate Tax $2,000
• Deductible Auto Registration $200
• California Resident. All California tax paid in year incurred.
• ISO exercised during 1998 for $1,000.
• Fair market value at exercise $200,000
• Stock sold during 1999, held more than 12 months after exercise and more than 2 years after grant, for $250,000

Tables

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• Federal (Incentive Stock Option)
• Federal Alternative Minimum Tax
• Federal Minimum Tax Credit
• California (Incentive Stock Option)
• California Alternative Minimum Tax
• California Minimum Tax Credit

Assumptions

The same, except the option is a non-qualified employee stock option.

• Federal (Non-Qualified Stock Option)
• California (Non-Qualified Stock Option)

Comments:

As you can see, the total out of pocket tax with the incentive stock option for the two years is $137,203, compared to $149,643 with the non-qualified stock option. There is also an unused Federal minimum tax credit of $17,550 that may be applied in future years.

The adjustment for the incentive stock option "preference" is reversed in the year of sale, enabling a portion of the minimum tax credit to be used at that time.

Good luck!

Mike Gray

For more information about incentive stock options, request our free report, Incentive Stock Options - Executive Tax and Financial Planning Strategies.

For more information about non-qualified stock options, request our free report, Non-Qualified Stock Options - Executive Tax and Financial Planning Strategies.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this answer was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.