1. Is there tax on the exercise of an incentive stock option (ISO)? - ISOs are afforded special tax benefits. There is no regular income tax on the exercise of an ISO. However, the difference between the exercise price and the fair market value on the date of the exercise is a tax preference item for the alternative minimum tax (AMT). So, if the AMT applies, there could be a tax on the exercise of an ISO.
2. What is the significance of the alternative minimum tax (AMT)? - The AMT was designed so that taxpayers with sophisticated situations and large deductions would not escape paying some tax. If you exercise a significant amount of ISOs, you could be subject to the AMT and have a larger than normal tax to pay at April 15. This would be in addition to the amount of cash used to exercise the ISOs. Therefore, when exercising ISOs, you must do a careful analysis to determine the appropriate number of ISOs to exercise in order to minimize or eliminate the AMT.
3. Are there any time requirements to meet in order to receive the special tax benefits? - To avoid the regular income tax on the exercise of an ISO, you must not sell the stock before the later of two years from the date of the grant, or one year from the date of exercise. If you hold the stock for the requisite time period, the subsequent sale of the stock results in capital gain, which is taxed at a maximum tax rate of 20%. (Example, assume the options were granted on January 1, 1999 and the options were exercised on April 1, 1999. You would have to sell the stock after January 1, 2001 in order to receive the special tax benefits).
4. What happens if the time requirements are not met? - If the stock is sold before meeting the requisite time requirements, it is a disqualifying disposition and will be taxed as if it were a NSO. Therefore, the difference between the exercise price and the fair market value on the date of exercise, is income to be included on the W-2 form. It will be subject to withholding as discussed in paragraph 8 above. If the selling price exceeds the value at the date of exercise, the balance is taxed as a short-term capital gain, which is subject to tax at the regular income tax rates.
5. What is the tax basis of stock acquired by the exercise of an ISO? - The tax basis of stock acquired by the exercise of an ISO is the exercise price. If there is a disqualifying disposition, the tax basis is equal to the fair market value on the date of exercise.

We have experience guiding clients through the maze of stock option decisions. For more information contact Nick Puniello at nick@cpapd.com.