With incentive stock options (ISOs), you could be on your way to a very nice payout.
But you must consider both the regular federal income tax results and the alternative minimum tax (AMT) results.
In addition, you must pay attention to special rules that apply to so-called disqualifying dispositions of shares acquired by exercising ISOs. This sounds complicated, and it is a little, but we can help.
You will eventually sell shares acquired by exercising ISOs, hopefully for a healthy profit. Your tax planning objectives are to
- have most or all of that profit taxed at lower long-term capital gains rates, and
- postpone paying taxes for as long as possible.
Regular Tax Results
Under the regular federal income tax system, ISOs deliver two major advantages.
First, when you exercise the ISO, the excess of market value over the exercise price (the so-called bargain element or spread) goes untaxed.
Second, when you sell the ISO shares, the entire profit (excess of sale price over exercise price) can potentially qualify for favorable long-term capital gains treatment. But for long-term capital gains treatment to apply to the entire profit, the date of sale must be
- more than two years after the option grant date (when you were given the option), and
- more than 12 months after you acquired the shares by exercising the option.
If you satisfy these two timing rules, you can achieve the twin goals of (1) having the entire profit taxed at favorable long-term capital gains rates and (2) delaying the tax bill until you sell the option shares, meaning you will have the cash from the stock sale to pay Uncle Sam (and your friendly state tax collector, if applicable).
With ISO shares, the bargain element on the exercise date counts as a positive adjustment for AMT purposes (positive for the U.S. Treasury, negative for you). The adjustment increases your AMT income in the year of exercise, which may cause the AMT to exceed your regular federal income tax bill. If so, you must pay the higher amount. If not, the adjustment does you no harm.
If you wind up owing AMT in the year of exercise, you may be entitled to an AMT credit, which can be used to reduce your regular federal income tax bill in a later year.
Key Point. If your AMT victimhood is caused by exercising ISOs, you will probably earn an AMT credit.
When you sell ISO shares, the resulting gain or loss must be calculated under the AMT rules:
- The AMT basis equals the market price on the exercise date (not the lower exercise price, which is the regular tax basis).
- The higher AMT basis shows up as a negative adjustment on your Form 6251 for the year of sale.
So, if you sell for more than the market price on the exercise date, you have a gain for both AMT and regular tax, but the AMT gain will be lower.
If you sell for less than the market price on the exercise date but more than the exercise price, you have an AMT loss and a regular tax gain.
In either case, you earned an AMT credit for the year of exercise, and if you have not yet used the credit, you can probably use the credit in the year of sale.
While the AMT rules were crafted to be difficult to game, that does not mean there are no games to be played.
Stagger Exercise Dates
Staggering the exercise of ISOs over several years may allow you to avoid triggering the AMT. Unfortunately, this ploy may not work if the stock continues to rise. As the stock goes up and up, the bargain element on the remaining unexercised ISO shares gets bigger and bigger, which means it gets harder and harder to avoid the AMT.
But staggering can make good sense near year-end. For example, you can exercise some ISOs in December of the current year and exercise the rest early in the following year. Assuming the stock doesn’t rise much between the two exercise dates, you might successfully avoid the AMT in both years.
Another strategy is to simply exercise the ISOs before the stock price advances much beyond the exercise price. Then the bargain element is minimal, and the AMT bill will be zero or negligible.
Of course, to use this strategy, you must come up with the cash to exercise sooner rather than later. So, this ploy makes sense only if you strongly believe the stock will rise enough to justify the cash-out-of-pocket investment.