Alternative Minimum Tax and Incentive Stock Options
Tax Trap--Beware!!
If your company granted you Incentive Stock Options (ISO), sometimes called "Qualified Options", and you exercied them you may have a
HUGE tax problem.
There are two kinds of stock options, ones that are qualified by the Internal Revenue Service and ones that are not. The ones qualified by the IRS are called "Incentive Stock Options", the otheres are "Non-Qualified Options" or "Regular Options." Each is taxed differently. The problem with Incentive Stock Options is that they are a "tax-preference" item and are subject to a parallel tax called the Alternative Minimum Tax (AMT). By exercising them you can find yourself having a
large tax bill and no income to show for it!
First, the Alternative Minimum Tax (AMT). This tax was enacted a long time ago to make extremely wealthy individuals pay at a fair share of tax. Because the AMT was never indexed for inflation and was enacted many years ago it is now affecting regular middle income taxpayers and with avengence and this is how:
You won't have a problem with Incentive Stock Options if you sell your stock in the year they are exerciesd. However, if you hold the ISO stock, (hoping to get favorable Long Term Capital Gains tax rate), or you cannot sell your stock due to securities regulations or your stock lacks of buyers, you could end up paying an
ELEPHANTINE tax! This could happen when an ISO is exercised.
To compute the tax, you must add up the difference between the exercise price and the Fair Market Value and compute that as a "Preference" in the Alternative Minimum Tax. For example, if you were given ISO stock options on 3,000 shares of company "X" stock that had a Fair Market Value of $100.00 per share and your option price was $1.00 per share you would have to report $297,000.00 (3,000 shares x [$100.00 - $1.00 = $99.00] = $297,000.00) of AMT income and could owe $83,000.00 of AMT tax on that AMT income!! Remember, you have
NOT sold the stock yet, so you have not received a dime of income.
Look what happens if at the end of the year and your stock price goes from $100.00 to $20.00 per share and you don't sell it. Due to the AMT you will have to pay the IRS $83,000.00 on your stock, but your stock will only be worth $60,000.00. You will owe $23,000.00 more than you could sell your stock!
Believe it or not, in the year 2000 there were a lot of people who did not understand the complicated AMT and got ISO stock. After the close of the tax year when they had their tax returns prepared they suddenly realized they owed a GIANT tax bill. This bill was sometimes greater than hundreds of thousands of dollars in taxes and when their stock was worth far far less! Frequently, these people did not have enough money to pay their tax bills.
Disclaimer: The information in these web pages has been prepared as a
service to the community and does not constitute legal advice. This
information may not apply to your situation particularly if you do
not live in the state of California. Do not make legal decisions based
on this material. Consult an attorney in person before making any
important legal decision.
