The tax rules for incentive stock options (ISO) are complex. Using the example below will help to understand the tax treatment of ISO.

We frequently get calls asking for advice on incentive stock options. For example, I want to share a conversation I recently had with someone I will refer to as Wally Backman. He works for a ride sharing company and was granted incentive stock options  (“ISO”) for 10,000 shares with exercise price of 24 cents, that he is fully vested in, and the current stock price is assumed to be $5 on the date of exercise. He says he has one month to decide whether to exercise the stock or he will forfeit the options. He wants to know if he should exercise his stock options and what the tax ramifications are for doing this. Wally says he heard at a party that he would not be subject to AMT because his income is less than $1 million.

Should you believe everything you have heard at a party?

Firstly, we need to understand the ISO and its terminology with background on terms for ISO.

Here are some tax terms for Incentive stock options:

  • Option Grant date- the date the ISO is granted.
  • Strike price– this is the cost to purchase a share of stock. This is usually set on the grant date.
  • Vesting period– option cannot be exercised until vesting period is over. This is also usually established on date of grant. For instance, vesting period might be 12 months from date of grant. There might also be a window that limits the employee on how long they can defer to exercise the options.
  • Exercise date– the date on which the option was exercised and shares purchased.
  • Selling price– the gross amount received from selling the stock.
  • Selling date– the date on which stock is sold.
  • Holding period to get favorable long-term cap gain rate on sale– the sale of stock must be at least two years after the option grant date and the stock must be held more than one year after exercise date.
  • Disqualifying disposition– when the hold period is not met. These rules are not covered herein.

Then we need to understand the tax rules for exercise of the ISO.

There is no regular tax on the date of exercise of the shares.  Regular tax is not triggered until the sales date when stock is sold.

However, for Alternative Minimum Tax (“AMT”) the exercise date is a taxable event.  The difference between strike price and value of the stock on date of exercise is a tax preference for AMT. Using the facts in the example above for Wally Backman, the AMT preference would be $4.76 per share times 10,000 shares which is tax preference of $47,600. We will discuss the tax rules in section below (for tax on exercise).

Now let’s assume the stock is held for requisite period (more than two years after date of exercise) and then sold for say $40 per share. Wally’s basis in shares for regular tax would be $.24 x 10,000 shares or $2,400. Wally’s basis in shares for AMT would be $5 x 10,000 shares or $50,000. See below for summary on year of sale of stock.

Tax projections would then allow us to understand the tax impact of exercise.

It was time to level with Wally. What he heard at the party is only partially true. Most individual taxpayers with AGI below $1M will not likely be subject to AMT for 2019. However, for taxpayers with ISO exercise, they often will be subject to AMT even with income excluding the stock option exercise of far less than $1M.

We will need to prepare a tax projection to determine the impact of exercise. Let’s assume Wally projected his taxable income would be about $95,000.

We determined that Wally would owe about $1,600 of federal AMT resulting from exercise of the option. I heard a loud gulp after we had finished the tax projections and gave him the conclusion of our findings. Wally was determined his company would be the next Amazon and agreed to pay the extra tax.

Finally, a calculation of the tax impact on sale of stock.

For purposes of this exercise, Wally said to assume the stock would be worth $100 per share in 2021 on the date he was legally able to sell the shares, and this was more than two years after the grant date.

He would have capital gain for regular tax purposes of $997,600 (1,000,000 less cost basis $2,400).

He would have capital gain for AMT purposes of $950,000 (1,000,000 less cost basis of $50,000).

So, there would be large capital gains tax in 2021. The fact there is lower AMT cap gain in 2021 would not reduce his tax. He still would have to pay tax on the $997,600 for regular tax based on tax projections for 2021. We determined he would not be subject to AMT tax in 2021 so he could not recover the $1,600. The rules in this area are very complex and there is no rule of thumb about what the conclusions were likely to be.

I told Wally he would need to do additional tax planning for 2022- 2024 to see what if anything he could do to recover the tax paid in 2021.

Conclusions

Jerrold Kahn

Before you exercise the ISO you should engage a CPA to do these calculations. This may require multiple years of tax planning to ensure you have the best understanding of all consequences.

In the example we covered, Wally had a small tax preference with AGI of about $95,000 and still paid AMT. This tax was not high enough to cause Wally to fail to exercise his ISO’s. You should have this information before you exercise the options to be able to make informed decisions.

In addition, it is important to test what could go wrong and what the tax effects of this are. Let’s assume the tech company went bankrupt after the exercise date. Wally would pay $1,600 of AMT tax for 2019 tax year and in 2021 and would have a large AMT capital loss. He would likely never recover the AMT tax paid.

In addition, if the holding period was not met or Wally left the company prematurely, this would be a disqualifying disposition. These rules are beyond this article.

ADDITIONAL ARTICLES BY JERRY KAHN