ISOs in a down market.

• Author: Koppel, Michael D.
• Position: Incentive stock options

In this time of tight labor markets, many companies offer incentive stock options (ISOs) to attract and retain talent. Before the decline in the stock market this spring, many employees had large paper gains after they exercised these options. Traditional tax planning has tried to find solutions for taxpayers who own stock worth significantly more than an ISO exercise price. But what about the employee who exercised ISO stock before the March/April correction and still holds it? This investor/employee may have the worst of two worlds: alternative minimum tax (AMT) to pay on April 15, 2001, and stock that has decreased in value. Although there is no "alternate valuation" date for ISO stock, there may be a way for employees to escape from this situation.

ISOs

ISOs offer two tax benefits. First, an employee can convert ordinary income into capital gain income. Second, the employee enjoys economic income by buying stock at a bargain price, but defers the tax liability until the stock is sold.

An ISO grants employees a right to buy stock at market price on the option's grant date. To enjoy tax benefits, an employee must not sell his stock before the earlier of two years after the option's grant date or one year after exercise.

Example: Employee T exercised an option to buy 10,000 shares of a publicly traded stock for $5. The stock was worth $55 on the exercise date, but a market correction has reduced the stock price to $10.

Regular Tax Rules

For regular tax purposes, ISOs do not result in taxable income on the option grant date or when an employee exercises the option (Sec. 421). There is no reporting requirement. Basis is the cash price paid and the capital gain holding period begins to run on the exercise date. As long as the option holder owns the stock for the required holding period, the stock is a capital asset that can give rise to capital gains. If the employee sells the stock before the end of the required holding period, any income is ordinary (compensation) income.

AMT

Although the exercise of an ISO does not create taxable income, it does create income for AMT purposes. The additional AMT income is the difference between fair market value (FMV) and the exercise price, multiplied by the number of exercised shares.

In the example, T would have $50,000 of additional AMT income. This can be a big problem, particularly for an employee whose AMT income is in the AMT exemption phaseout range (i.e., between $150,000 and $330,000 for a...