Incentive stock options are a popular benefit that companies use to reward their top-performing employees. If managed properly, they can also be a lucrative addition to an individual’s investment portfolio and help them grow their wealth. At the end of each year, individuals who have been rewarded ISOs often ask themselves whether they should exercise them or hold the stock until the following January. Often, a most critical factor that gets overlooked in the decision-making process is whether exercising the ISO will trigger the Alternative Minimum Tax.

Before making any determinations about exercising options and the AMT, it’s imperative to first become familiarized with how stock options work.

Basic ISO rules

It’s important to understand that employer stock options fall into two categories: nonqualified options and incentive stock options (qualified). Although both options allow employees to purchase a set amount of shares of company stock at a fixed price for a limited period of time, they are treated differently for tax purposes. For instance, Nonqualified stock options do not trigger the AMT but…. are always taxed at ordinary income rates.

ISOs, in contrast, receive more favorable tax treatment and gains are generally taxed at capital gains rates if certain statutes are met. In order to qualify for ISO treatment, the following conditions must be met:

• The employee must hold the stock for at least one year after the exercise date and for two years after the grant date
• Only $100,000 of stock options can become exercisable in any calendar year - this value is measured by the options’ fair market value on the grant date
• The exercise price must not be less than the market price of the company’s stock on the date of the grant
• The option must be exercised within 10 years of the date of grant
• If, at the time of grant, the employee owns more than 10 percent of the voting power of all outstanding stock of the company, the ISO exercise price must be at least 110 percent of the market value of the stock on that date and may not have a term of more than five years

Tax treatment of stock options

With Nonqualified options, employees pay ordinary income tax on the difference (the spread) between the grant price - which is the value of the stock the day employers and employees initiated the stock option contract - and the price at which they exercise the option. For instance, assume that employees are granted the option to purchase 100 shares of stock at $20 per share for 10 years. If, after 7 years, the stock has increased to $50, employees may purchase these $50 shares at $20. When exercising the right to buy the stock, they would pay taxes on the $30 spread at ordinary income rates. Additionally, the company receives a corresponding deduction.

With ISOs, however, employees are not subject to ordinary taxes when they choose to exercise their right to purchase the stock and the company doesn’t receive a deduction. Instead, they are later taxed at a capital gains rate unless the holding period requirements are not met. When the holding periods are not met they are then taxed at ordinary income rates.

To better determine the way in which ISOs are taxed, see below for events and their corresponding tax treatments:

• The mere grant of an option will not trigger tax implications
• Exercising an option does not trigger ordinary taxes - however, the bargain element of an ISO may trigger alternative minimum tax
• If the shares are sold immediately after they are exercised or do not meet the holding requirements, the bargain element is treated as ordinary income
• If the stocks have been held for 12 months after exercise and two years after the grant date, gains will be treated as long-term capital gains

Employees who are unsure whether to exercise an ISO can benefit from meeting with a tax professional who can perform an AMT and other tax projections.

For more information on employee stock options and how different choices affect your taxes, please contact Norman LeBlanc, CPA or any member of our Tax Services Group at 888-857-8557.