Weighing your options: tax planning for incentive stock options.

• Author: Rogers, Allison

This article provides an overview of the income tax and AMT implications of exercising ISOs, and holding or disposing of stock acquired on exercise.

Employee stock options are frequently part of the compensation packages corporations offer to employees. These options are either statutory (also "qualified") or nonstatutory (also "nonqualified"). In very general terms, nonstatutory options trigger gross income to employees at either grantor exercise, and concomitantly produce deductions for employers.(1) Statutory options, by contrast, afford special tax benefits to employees; they generally do not trigger income, and consequently employers are denied offsetting deductions.(2) Nonstatutory options are more prevalent than statutory options probably because vesting is not limited by amount and because employers are allowed offsetting deductions. Recently, however, statutory options have become popular, especially among technology employers, many of whom have soaring stock values, but lack current earnings, and consequently are less concerned with deductions.

Statutory options include employee stock purchase plans and incentive stock options (ISOs), both of which allow employers to share stock appreciation with employees. Employee stock purchase plans, like qualified retirement plans, are restricted by nondiscrimination rules and usually defer the realization of appreciation until an employee's retirement.(3) ISOs, however, are not restricted by the nondiscrimination rules and allow corporations to target employees who are most likely to influence stock value. Moreover, these employees may realize stock appreciation in relatively short periods of time (and, importantly, while they are still employed). With the explosion of stock value, however, many ISO holders will be subjected to a hefty alternative minimum tax.

Statutory options qualify as ISOs only if they comply with the requirements set forth in the Internal Revenue Code of 1986, as amended.(4) In general, an ]SO must be granted pursuant to a written plan that may not continue for more than 10 years. ISOs granted under the plan must be granted to employees, and lapse within 10 years of grant. The exercise price (strike price) must meet or exceed the fair market value (or 110 percent of the fair market value, if the optionee is a 10 percent shareholder) of the underlying stock at grant. Moreover, an option qualifies as an ISO only to the extent it annually vests the right to purchase no more than $100,000 of stock valued at grant. If an option vests more, it qualifies only with respect to the first $100,000 of stock vesting per annum, and is deemed nonstatutory with respect to additional shares, provided, however, that the plan allows for both statutory and nonstatutory options.

This $100,000 restriction limits only the value of stock vesting in a given year, not the value of stock an optionee may acquire. Thus, if an ISO qualifies with respect to vesting shares (and otherwise), an optionee generally may exercise with respect to vested or unvested shares, in whole or in part, at any time prior to lapse. An optionee must exercise, however, while employed by the grantor or within the statutorily prescribed extension periods. In addition, an ISO may not be transferred except by will (or pursuant to the laws of descent) or be exercised except by the optionee (or the optionee's estate or guardian). Finally, upon exercise, the optionee must hold acquired stock for at least two years after grant and one year after exercise. If the optionee disposes of acquired stock, by sale or remission, prior to expiration of either holding period, the option is deemed nonstatutory with respect to those shares and is taxed accordingly.

Although this article focuses on the federal tax implications of exercising ISOs, and holding or disposing of the stock acquired on exercise, ISOs necessarily implicate career, investment, and securities law issues. For example, because an ISO generally must be exercised while an optionee is employed by the grantor, an optionee's career mobility or job security may influence the timing of exercise. In addition, if an optionee is an "insider" pursuant to the securities laws, or acquires stock not subject to a registration statement, the optionee's ability to dispose of stock may be limited by statute. Even if disposition is not limited statutorily, it may be limited contractually through a market standoff or the grantor's right of first refusal. Finally, if an optionee's stake in the grantor's stock represents a majority of the optionee's net worth, diversification issues may dominate tax strategies. Although this article highlights some nontax issues associated with ISOs, it does not address them in detail. Before counseling the holder of an ISO, tax advisors should consult other experts, such as financial planners and securities attorneys to assist in considering these nontax issues.

Income Tax Implications of an ISO

To the extent an option qualifies as an ISO, the optionee is not taxed at grant or exercise, except pursuant to the alternative minimum tax, discussed below. In general, on exercise of an ISO, an optionee acquires stock with a basis equal to the strike price, and any excess value is not currently taxed as income. When the optionee subsequently sells the stock, any gain usually is taxed as capital gain.

To illustrate, assume that (a) in 1998, an optionee is granted an ISO to purchase stock at $5 per share; (b) in 2000, the optionee exercises when the stock's fair market value is $100; and (c) in 2005, the optionee sells the acquired stock when the fair market value is $145. To the extent the option qualifies as an ISO, the optionee is not taxed at grant (in 1998) or exercise (in 2000). At exercise, the optionee pays $5 per...