View PDF

The tax treatment of stock options depends primarily on whether the options are incentive stock options (ISO) or nonqualified options (NQO).

ISO's do not result in a regular tax liability when the options are granted or when exercised. However, the exercise of such options does result in an adjustment for Alternative Minimum Tax (AMT) purposes equal to the difference between the exercise price and the grant price. This means that an employee who exercises ISO's may incur a substantial AMT tax even though no cash is received. The individual does not incur a regular tax liability until the stock is sold, resulting in a capital gain. Long-term capital gain rates apply if the holding period requirements are satisfied. If the stock is sold in a disqualifying disposition, meaning that the stock is not held until over two years after the ISO was granted and over one year after the stock was acquired, the individual will incur compensation income instead of capital gain.

The AMT problem can be prevented by immediate sale of the stock. However, this results in the gain on sale (the difference between the grant and exercise price) being treated as ordinary income.

When an AMT tax is paid as a result of the exercise of ISO's, up to the full amount of the tax may be recovered in future years as a credit against regular tax. This depends on the regular tax exceeding the tentative AMT tax in the year of credit. This will usually occur when the stock that was acquired in the exercise of options is sold, since this stock will have an AMT basis that is higher than the regular tax basis and there will be a negative AMT adjustment that is equal to this difference.

There is no guarantee that recovery of the AMT tax will occur, since there are a number of possible events that could prevent the credit from being usable in any given year, such as the exercise of additional ISO's in the year stock from earlier years is sold. There could also be other substantial amounts of AMT adjustments in the return such as deductible taxes paid or miscellaneous deductions that would have the effect of increasing the tentative AMT. Also, if the market value of the stock declined significantly, there might not be sufficient regular tax exceeding the tentative AMT to use the AMT credit against.

As indicated above, holding stock acquired by exercising ISO's for long-term capital gain treatment can be risky since one may pay a large amount of AMT tax and then be unable to recover this tax via the AMT credit when the stock is sold. This is in addition to the investment risk of holding a large amount of a single stock (lack of diversification). Also, the employee is dependent on the same company for his or her livelihood.

Exercise of Nonqualified Stock Options generally results in an immediate tax. The difference between the exercise price and the grant price is treated as wages, subject to withholding taxes and is included in the individual's Form W-2. If the stock is not sold and regular wages are not sufficient to cover the amount of the withholding taxes, the individual will have to pay the taxes from his or her own funds. Accordingly, it is generally desirable for the individual to sell enough stock to cover at least the amount of taxes due in a "cashless exercise" which is typically done for publicly traded securities.

There is no AMT adjustment resulting from the exercise of nonqualified stock options, since the gain is taxed as ordinary income regardless of whether the stock is immediately sold.