ISOs and the AMT.

• Author: Topolski, Mark R.
• Position: Incentive stock options and alternative minimum tax

While incentive stock options may seem like an ideal corporate perquisite, they can also trigger alternative minimum tax consequences that can minimize their advantages. This article examines the interplay between ISOs and the AMT and offers planning strategies.

Companies are offering a number of incentive packages as a means of attracting and retaining key employees in today's tough market. One type of incentive plan allows employees to share in the benefits of company ownership. There are many plan variations available to companies seeking to offer their employees this type of opportunity, including employee stock purchase plans, stock appreciation rights, options to purchase stock at a set price in the future and many others. Each plan type carries unique tax consequences for the employee and employer.

SOPs can have some unique twists. In a basic SOP, an employee is granted options to purchase company stock at a fixed price in the future. The taxation of the option grant, option exercise and the subsequent sale of the stock depends on whether the option is an NQSO or a statutory ISO.

NQSOs vs. ISOs

NQSOs

ISOs are afforded special tax treatment under Sec. 422. NQSOs are stock options that are not ISOs. The main differences between ISOs and NQSOs are the statutory restrictions placed on ISOs and their favorable tax treatment. Under Sec. 422(a), for an option to qualify as an ISO, the grantee must be an employee of the company, its parent or subsidiary, or of a corporation that assumes responsibility for the options as a result of certain reorganizations, mergers, consolidations, acquisitions or liquidations described in Sec. 424(a). Under Secs. 422(b)(2), (3) and (d), an ISO plan cannot continue for more than 10 years from the earlier of plan adoption or the date the plan receives shareholder approval; further, the value (determined at the time of grant) of the stock that can be exercised for the first time during any year by an employee cannot exceed $100,000.

Generally, there are no tax consequences at the grant date for either ISOs or NQSOs. However, if an NQSO has a readily obtainable FMV at the grant date, there may be immediate tax consequences, according to Regs. Sec. 1.83-7(a).

When NQSOs are exercised, the spread between the FMV of the stock at the exercise date and the option exercise price is compensation income to the employee and a deduction to the employer. The stock basis is the FMV on the exercise date. An employee must pay withholding tax when the options are exercised.[1] An employee can instruct the plan administrator to exercise options and sell the stock to pay the tax, a "cashless" exercise. The stock sale proceeds are used to pay the exercise price and the taxes, with the employee receiving the excess. An employee can also exercise options, sell sufficient stock to cover the exercise price and taxes and hold the remaining stock. Another alternative is for the employee to pay the exercise price and taxes and hold all of the stock. The subsequent disposition of the stock will yield a capital gain or loss under Sec. 1221.

Planning for the exercise and disposition of NQSOs includes addressing cashflow issues and the stock's expected appreciation. The assumption is that the stock will appreciate from the date of option grant to the date of exercise, because an employee will not exercise options if the stock's FMV is less than the exercise price.[2] If an employee wants to obtain company stock at a depreciated price, he can buy it on the market; the same is true with ISOs.

ISOs

The taxation of ISOs may seem simple, but there are hidden complexities that could catch an unenlightened employee. For an employee, the advantage is that there are no regular tax consequences on option exercise, according to Secs. 422(a) and 421(a)(1); however, the employer does not get a deduction. Under Sec. 1011, the basis of the stock is the exercise price. On stock disposition, the spread between the FMV of the stock at sale and the exercise price triggers capital gain or loss under Secs. 1001(a) and 1221. If an employee disposes of the stock prior to (1) two years from the grant date or (2) one year from exercise date (a disqualifying disposition), the tax treatment under Sec. 422(a)(1) is similar to that of NQSOs. In the disposition year, the spread between the FMV of the stock on the exercise date and the exercise price is compensation income under Sec. 421(b).

The AMT Quandary

ISOs carry AMT consequences.[3] The exercise of an ISO triggers an AMT adjustment under Sec. 56(b)(3) for the spread between the FMV at exercise and the exercise price, if the exercise is not a disqualifying disposition. The adjustment is an increase to AMTI as a deferral adjustment item under Sec. 56. When AMT is calculated, the adjustment is not capital gain, according to Sec. 56(b)(3). Thus, AMT on the adjustment is calculated at either 26% or 28%, depending on AMTI. Under Sec. 55(b)(2), this adjustment is coupled with other AMT adjustments to determine whether the taxpayer has to pay AMT.

If a disqualifying disposition occurs, the AMT consequences are mitigated. If it occurs in the year of...