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Incentive
Stock Options
This
article is about the federal income tax rules for incentive stock
options. It is common knowledge that start-up companies, particularly
in high tech fields, hire and retain employees by awarding Incentive
Stock Options (ISOs). What is not so well known, however, is the
careful tax planning required to minimize taxes and to avoid some
tax traps usually unexpected by employees. A particularly stinging
tax hazard for employees of rapidly growing companies is the alternative
minimum tax that may be imposed on the exercise of appreciated employer
stock acquired under an ISO. I hope that this article will help
you understand some of the basic rules involved in ISOs.
Regular income taxation of ISOs. There is no income tax imposed
when an ISO is granted. In addition, there is no income tax due
when the incentive stock option is exercised. The first ordinary
income tax event is the sale of shares acquired by exercise of an
ISO. At that time, the employee recognizes taxable gain equal to
the difference between the sale proceeds and the option price. If
holding period requirements are met, this gain is capital gain.
To obtain favorable long-term capital gain tax treatment, stock
acquired under an ISO may not be sold before the later of two years
from the date of grant of the option, or one year from the date
of exercise of the option.
For example: An employer grants an ISO to an employee on March 1,
1999. The employee exercises the option on September 1, 1999 (six
months after the grant). The employee should not sell the stock
until March 1, 2001, to achieve favorable capital gain tax treatment.
March 1, 2001 is at least two years from the date of grant and one
year from the date of exercise.
Since the exercise of the option is not an ordinary income tax event,
it is usually advisable (at least from the tax point of view) to
exercise the incentive stock option as early as possible.
Early exercise of the options is even more important if the stock
is appreciating. This will enable the employee to be in a position
to sell the stock at the earliest possible date (i.e. two years
after the grant) at capital gain tax rates. However, the employee
may not want to sell the stock until as late as possible to defer
taxes.
If the ISO holding period requirements are not satisfied, the difference
between the fair market value of the stock at the time of exercise
and the option price is taxed as compensation. Compensation is taxed
as ordinary income, not as capital gain. The ordinary income tax
is incurred in the year the stock is sold, not necessarily the year
the stock is acquired under the ISO.
Since capital gain treatment on the sale of stock acquired under
an ISO is crucial, it is important to know certain key dates. The
date of grant of the incentive stock option is the date on which
the board of directors completes the corporate action constituting
an offer of stock under the ISO. The date of the grant is not the
date on which the option agreement is prepared.
Alternative minimum tax on exercise of ISO. The more rapidly the
underlying stock appreciates, the greater the risk the employee
will owe alternative minimum tax (AMT) on the exercise of the option.
This is because the alternative minimum taxable income (AMTI) includes
the difference between the fair market value of the stock on the
date the incentive stock option is exercised and the price paid
for the stock (the "ISO spread"). However, the AMT only applies
if it is higher than the employee's regular income tax.
The employee who incurs AMT may have to pay it from funds other
than proceeds of sale of the stock. This would occur when the stock
is acquired, but held for the period needed to obtain capital gain
treatment. This risk of phantom AMTI makes avoiding the AMT very
important tax planning.
Be sure to consult with a tax advisor for proper planning and implementation
of thx savings ideas to be sure they are right for you.
C.
David Pitzer, CPA, PC
118
Two Mile Pike
Goodlettsville, TN 37072
(615) 851-2727
Fax: (615) 851-8711
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