Exercising ISO can be a nightmare

            Quite a few employers today use Incentive Stock Options to attract and retain talent. Exercise, Selling and Managing ISOs can be a nightmare. 

            One of the key difference between ISO and Non-Qualified Stock Option is that you don't have to report compensation income when you exercise an ISO but most likely you will end up paying a good amount of tax because of the AMT treatment. For the purpose of the regular income tax, the exercise of an incentive stock option is a non-event. But when you exercise an ISO you have to make an adjustment under the alternative minimum tax. The amount by which the fair market value of the stock exceeds the amount you paid for it, ie the 'spread' tends to incur an alternative minimum tax.

            The bargain element on your exercise of an ISO is usually the event that triggers the AMT liability. But the amount of the tax liability depends on many other aspects of your individual income tax return. If your bargain element is large, the AMT can be 28%.

            Some of your AMT liability will be eligible for use as a credit in future years. Please note that this credit can only be used in years when you don’t pay AMT. It reduces your regular tax only.

            You will report a smaller amount of gain for AMT purposes when you sell the stock. As for the purpose of sale, the stock’s AMT basis is equal to the amount you paid plus the amount of the AMT adjustment.

            In order to understand the Regular tax treatment and the Alternative Tax treatment lets take an example:

            Your employer grants you an ISO which you exercise by paying $45 per share when the market value is $89 per share. 

            At this particular stage you are required to report an AMT adjustment of $44 per share. ($89 - $45)

            Later after holding it for a year, you sell the stock at $95 per share

            At this stage, for the purpose of Regular income tax you have to report a capital gain of $50 per share ($90 - $45)

            But for AMT purpose you report a gain of only $6 per share. As for AMT purpose your cost basis is $45 you actually paid and $44 you reported as an adjustment

            So $95 - $45 + $44 = $6

            Updated: 23 Dec 2014 09:46 AM
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