Incentive Stock Options
It is common
knowledge that start-up companies, particularly in high tech fields, hire and
retain employees by awarding Incentive Stock Options (ISOs). What is not so well known, however is the
careful tax planning required to minimize taxes and to avoid some tax traps
usually unexpected by employees. A
particularly stinging tax hazard for employees of rapidly growing companies is
the alternative minimum tax that may be imposed on the exercise of appreciated
employer stock acquired under an ISO.
We hope that this letter will help you understand some of the basic
rules involved in ISOs.
Regular
income taxation of ISOs. There is no income tax
imposed when an ISO is granted. In
addition, there is no income tax due when the incentive stock option is
exercised. The first ordinary income
tax event is the sale of shares acquired by exercise of an ISO. At that time, the employee recognizes
taxable gain equal to the difference between the sale proceeds and the option
price. If holding period requirements
are met, this gain is capital gain. To
obtain favorable long-term capital gain tax treatment, stock acquired under an
ISO may not be sold before the later of two years from the date of grant of the
option, or one year from the date of exercise of the option.
For example:
An employer grants an ISO to an employee on March 1, 1999. The employee exercises the option on
September 1, 1999 (six months after the grant). The employee should not sell the stock until March 1, 2001, to
achieve favorable capital gain tax treatment.
March 1, 2001 is at least two years from the date of grant and one year
from the date of exercise.
Since the
exercise of the option is not an ordinary income tax event, it is usually
advisable (at least from the tax point of view) to exercise the incentive stock
option as early as possible. Early
exercise of the options is even more important if the stock is
appreciating. This will enable the
employee to be in a position to sell the stock at the earliest possible date
(i.e. two years after the grant) at capital gain tax rates. However, the employee may not want to sell
the stock until as late as possible to defer taxes.
If the ISO
holding period requirements are not satisfied, the difference between the fair
market value of the stock at the time of exercise and the option price is taxed
as compensation. Compensation is taxed
as ordinary income, not as capital gain.
The ordinary income tax is incurred in the year the stock is sold, not
necessarily the year the stock is acquired under the ISO.
Since capital
gain treatment on the sale of stock acquired under an ISO is crucial, it is
important to know certain key dates.
The date of grant of the incentive stock option is the date on which the
board of directors completes the corporate action constituting an offer of
stock under the ISO. The date of the
grant is not the date on which the option agreement is prepared.
Alternative
minimum tax on exercise of ISO. The more rapidly the underlying stock
appreciates, the greater the risk the employee will owe alternative minimum tax
(AMT) on the exercise of the option.
This is because the alternative minimum taxable income (AMTI) includes
the difference between the fair market value of the stock on the date the incentive
stock option is exercised and the price paid for the stock (the “ISO
spread”). However, the AMT only applies
if it is higher than the employee’s regular income tax.
The employee who
incurs AMT may have to pay it from funds other than proceeds of sale of the
stock. This would occur when the stock is acquired, but held for the period
needed to obtain capital gain treatment.
This risk of phantom AMTI makes avoiding the AMT very important tax
planning.
Please do not
hesitate to call if you need any further explanation of the tax rules
surrounding incentive stock options, or if you’d like to discuss more
specifically how the rules affect your situation.
