Incentive Stock Options & AMT
On the surface, incentive stock options (ISOs) appear to be attractive, especially when compared to non-qualified stock options (NQOs). ISOs receive more favorable tax treatment than NQOs in most cases. For higher paid employees or those who exercise a large volume of options in a year, the ISO can be a hidden tax trap, however. When you exercise an ISO, you may trigger the alternative minimum tax (AMT), a more expensive tax obligation.
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The Good News
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You do not need to pay tax on the value of an ISO when you receive it or when you exercise it. If you hold the stock for at least one year after you purchase it or for two years from the date you received the option -- whichever is longer -- your profit when you sell the stock is long-term capital gain. This means you will pay a maximum of 20 percent tax on your entire profit.
The Bad News
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When you exercise an ISO, you qualify for an alternative minimum tax adjustment equivalent to the value of your exercise "spread" -- which is the difference between the market price of the stock and your option price. If you add enough of these adjustments, you may pay more tax than if you had used traditional calculation methods.
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Avoiding the AMT
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You can potentially avoid the AMT by exercising your ISOs in smaller increments over time. You can also attempt to reduce other AMT adjustment values by deferring certain types of compensation or taking capital losses. You also can sell your shares in the same year you exercise the ISO. Your gain will be taxed at ordinary income rates, but you will be exempt from the AMT, which is a preferable scenario in many cases.
Plan Ahead
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Ultimately, the best strategy is to plan ahead. You can estimate your taxes during the year and calculate your likelihood of owing the AMT if you exercise your ISO during the year. You also can plan to pay the AMT: The value of AMT you pay that is more than your normally calculated tax can be used as a tax credit in subsequent years. If you have ISOs and are concerned about the AMT, speak to a professional tax preparer or an accountant to discuss your options and determine your best strategy.
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