ISO portfolio planning issues.

• Author: Dennedy, James
• Position: Incentive stock options

Managing investments in any concentrated stock portfolio is challenging. When these portfolios include incentive stock options (ISOs), transactions require even more planning and careful analysis, as well as specialized knowledge.

The Basics

On the surface, ISOs are fairly simple: employers grant employees the right to buy company stock at some future period (typically from one to 10 years) at a pre-set price called the grant or strike price. The grant price usually approximates the stock's fair market value (FMV) at the grant date. If the FMV increases, employees would have a financial incentive to exercise their ISOs before the options expire and pocket the difference between the increased FMV and the grant price.

Unfortunately, complications arise due to the tax consequences of exercising ISOs. For ordinary Federal tax purposes, no tax consequences exist. However, the spread between the grant price and the FMV on the exercise date results in an alternative minimum tax (AMT) adjustment. If an employee sells the stock immediately after he exercises it, the tax and financial results are simple: the spread between the grant and exercise prices is treated as wages, taxed at the employee's marginal tax rate. Most public companies report these wages on the employee's W-2, and some have agreements with brokerage firms to withhold taxes.

Even though employees have a strong incentive to sell ISO stock for diversification, the Code gives them a reason to hold on to their ISO stock. Under Sec. 422(a)(1), if an employee holds the stock more than one year from the exercise date and two years from the grant date, the spread (and any appreciation since the exercise) would qualify for long-term capital-gain treatment at lower tax rates.

Employees pay large AMT balances on significant exercises of highly appreciated shares. They could claim a credit on the AMT attributable to the exercises if their regular taxable income exceeds their alternative minimum taxable income (AMTI) in later years. Therefore, the AMT that results from exercising ISOs is a tax prepayment of sorts, which employees can have refunded as an AMT credit when they sell their stock. This is because ISO stock has a different (and typically higher) basis for AMT than for regular tax purposes.

Example 1: Employee S exercises 1,000 ISOs with a cost or strike price of $20 per share, when the stock's FMV is $50. The AMT adjustment is $30 per share or $30,000. As a result, the stock's cost and...