ISOs and AMT traps.

• Author: Bakale, Anthony
• Position: Incentive stock options; alternative minimum tax

While stock options have been an integral part of executive compensation packages since the 1980s, they have never been as widely used or contained as many features as they do today. Increasingly, companies are implementing broad-based programs in which all (or most) employees, not just a handful of executives, are granted stock options. This trend, combined with unprecedented growth in the stock market during recent years, has caused stock options to represent a substantial portion of the compensation and net worth of many executives.

Although academicians and other professionals recommend that employees hold their options as long as possible, a 1996 study by two professors at Duke University and the University of North Carolina at Chapel Hill found that two-thirds of lower-level employees and one-third of senior executives exercise their options within six months of the options being vested and "in the money." The study also found that 90% of employees receiving stock options sold their stock immediately after they exercised their options. This would seem to suggest that employees either do not understand stock options or are otherwise unable to effectively maximize their value.

The development and implementation of an effective option strategy requires the optionee to make decisions not only as to when to exercise the stock options, but also as to how to exercise them. Companies usually provide several alternative means by which employees can exercise their stock options. The simplest form is for the employee to pay cash or write a check. Many employees, particularly nonmanagement employees, however, do not have the financial means to cover the cost of exercising their options. Therefore, many companies have established "cashless exercise" programs with brokerage firms, in which a broker briefly lends money to an employee to allow him to exercise the options. The broker then immediately sells the stock, repays the loan and provides the difference between the exercise price and the grant price (for a nonqualified stock option (NQSO), less amounts withheld for taxes) to the employee. Finally, some companies permit their employees to pay for option stock with previously owned shares of employer stock. Although the decisions as to when and how to exercise stock options are primarily investment decisions, proper tax planning, especially for incentive stock options (ISOs) and the myriad of alternative minimum tax (AMT) issues they create, is essential.

ISOs

The tax treatment of an option's exercise generally depends on whether the option is an NQSO or an ISO. An ISO is an option:

1. That is granted to an individual, for any reason connected with employment, by the employer corporation (or its parent or subsidiary), to buy stock of the employer corporation (or its parent or subsidiary);

2. That satisfies the ISO qualification requirements; and

3. Whose terms do not provide that the option is not to be treated as an ISO.

If an option does not qualify for treatment as a statutory option under Sec. 421, it is subject to the NQSO rules.

Taxation of ISOs

The taxation of ISOs is governed by Secs. 421 and 422, which generally provide that neither the receipt nor the exercise of an ISO has current tax consequences to the optionee; however, the optionee generally must include an AMT adjustment equal to the compensation income that would have been recognized had the option been treated as an NQSO.

Dual-Basis Assets

The difference in treatment of ISOs for regular and AMT purposes causes ISO stock to be a dual-basis asset; it has a different basis for regular tax and AMT purposes, regardless of whether the AMT adjustment from the exercise of an ISO caused the optionee to pay AMT. Subsequently, when the optionee sells the stock, the difference between the regular tax gain or loss and the AMT gain or loss is reported as an adjustment. Because the AMT...