STOCK OPTIONS
INCENTIVE STOCK OPTIONS
An incentive stock option (“ISO”) is an option issued to an employee that allows all gains to be subject to long-term capital gain treatment (15-percent maximum federal tax rate) if the taxpayer disposes of the option shares more than two years after the date the option is granted and more than one year after the date the option shares are purchased. Also, the employee must continue to be an employee until at least three months before the option is exercised. If these rules are not met, the gains from ISOs are ordinary income subject to federal tax rates as high as 35 percent.
However, there is a hidden cost to obtaining long-term capital gain treatment from an ISO. The “spread” (the difference between the fair market value of the shares on the purchase date and the option price paid for the shares) must be added into the taxpayer’s AMT calculation for the year the options are exercised. Any AMT attributable to the ISO spread generally is allowed as an AMT credit carryforward to offset regular taxes owed in future years. Thus, any AMT attributable to the ISO is effectively a prepayment of tax, not additional tax.
The Tax Extenders and Alternative Minimum Tax Relief Act of 2008 amended the AMT provisions to provide relief to those taxpayers with AMT attributable to the ISO adjustment. Any underpayment of tax that is outstanding as of October 3, 2008, resulting from such an adjustment, and any interest and penalty associated with such underpayment, will be abated. For those taxpayers who have paid the AMT on ISOs there will be no abatement or refund. Those taxpayers are provided relief in the computation of their minimum tax credit.
Planning Suggestion: If you are planning to exercise ISOs before December 31, 2009, consider deferring the exercise until after that date and sometime before April 15, 2010. Any AMT on such exercise would likely not be due until April 15, 2011, after the required one-year holding period for the stock has been met. At that time the option shares can be sold at long-term capital gains rates, with a portion of the proceeds used to pay the 2010 AMT liability.
If you have exercised an ISO in 2009 and the value of the stock has decreased, consider a sale before the end of 2009. This should reducethe AMT effect. The sale must be to a non-family member and the stock cannot be repurchased for at least 30 days.
NONQUALIFIED STOCK OPTIONS
When a taxpayer exercises a non-qualified stock option (“NQSO”) that does not have a readily ascertainable fair market value at the time of issuance (generally the case where the option or the option stock is not publicly traded), the spread (the difference between the stock’s fair market value and option price) is taxed as compensation income. When the taxpayer sells the NQSO stock, any subsequent appreciation is taxed as long- or short-term capital gain depending upon the stock’s holding period. Because the spread is taxed as ordinary income, taxpayers in the highest marginal federal tax bracket are taxed at 35 percent on the spread.
Planning Suggestion: If a taxpayer expects to be subject to AMT for 2009 and no AMT credit carryforward is expected, the taxpayer should consider exercising NQSOs. The accelerated ordinary income may be taxed at a maximum federal rate of 28 percent as opposed to 35 percent. In addition, all future appreciation is capital gain. When making this decision, the potential tax savings should be compared to the opportunity cost of accelerating the income taking into account the time value of money.