With the stock market having nearly doubled over the past two years, many individuals holding stock options that they received from their employers are giving serious consideration to cashing out the value in these options. This article discusses the two principal types of options and explains the different AMT issues associated with each.

Types of stock options

For tax purposes there are two types of stock options – "qualified" and "nonqualified." The official term for a qualified option is Incentive Stock Option, commonly referred to as an "ISO." Each employer has the discretion, through the design of its plan, as to which type of option it grants to the employee, and it is not uncommon for some employees to have both types. It is important to note here that it is the responsibility of the individual to understand what he has.

Stock option essentials

A stock option, like any other option, is a contract giving one person the right to buy property from another person at a predetermined price. If the underlying property (stock) increases in value, the value of the option correspondingly increases. If the value of the stock decreases, the option has no value. Options generally have a fixed term – five to ten years for stock options is common, so the employee must act within this period or the option will lapse.

Example – an employee is granted an option to buy 1,000 shares of his employer’s stock at today’s value of $50. If the stock increases to $60 before the option lapses, the employee can exercise the option, effectively buying the shares from the employer at a discount and, in this example, realizing a $10,000 gain. To alleviate the hardship of asking the employee to write a check for the $50,000 exercise price, employers commonly arrange with a broker to allow what is referred to as a "cashless" exercise involving a same day sale. In this situation, on the date of exercise the broker sells an equivalent number of shares, and then sends the employer the $50,000 along with enough to cover the tax withholding requirements. Then, at the close of the market’s three-day settlement period, the net amount ($10,000 less taxes) is credited to the employee’s account.

Tax results from option exercise

Nonqualified option – on the date of exercise the $10,000 in the above example is taxable income. This is ordinary income, not capital gain, just as if it were part of the employee’s salaries and wages. The $10,000 will be included in taxable income reported in the employee’s W-2 at the end of the year.

ISO (qualified option) – The $10,000 will not be taxed as income on the date of exercise. Instead, it is a tax preference item for purposes of the AMT, meaning that Alternative Minimum Taxable Income will be higher than the employee’s Regular Tax taxable income by $10,000. The number in this example is relatively small, but if the preference item from an ISO exercise is large enough the employee easily can find himself stuck in the AMT. If the individual already is in the AMT, the hit from an ISO exercise will make it just that much more painful.

Tax planning for option exercises

The exercise of a nonqualified option does not have any direct AMT consequences. As an individual’s taxable income increases, however, the Alternative Minimum Tax exemption is phased out, so testing for the impact of this is important before exercising even a nonqualified option.

Especially critical, however, is tax planning before doing an ISO exercise. In order to exercise an ISO without triggering the Alternative Minimum Tax, the individual has to do the tax calculation under alternative assumptions as to the size of the exercise, as well as consider doing the exercise partially in one year and partially in the next. By doing this it certainly is possible to minimize the impact of an ISO exercise. Note also that the employee has a period of time after the exercise within which a sale of the stock will constitute a "disqualifying disposition," thus negating the AMT effect and retroactively treating the transaction as if it were instead a nonqualifying option.

Summary

The underlying investment decision as to the right time to cash out of employee stock options must, of course, must be the individual’s primary focus, but if that exercise will bring along with it a big AMT hit taxes need to be considered in deciding how many options to exercise and in what year they are exercised. That nice chunk of extra income the employee thinks he is getting can be seriously eroded by improper tax planning.