Incentive Stock Options, AMT and Qualifying Dispositions- Oh My!

If you have incentive stock options (ISOs) from your employer, you’ve likely considered when to exercise your options, and whether that will trigger the dreaded AMT. 

What are Incentive stock options (ISOs)?

Incentive stock options or ISOs are a type of stock option. A stock option is essentially the right to buy your company’s stock at a set price. They are commonly granted to employees as a part of their compensation package, especially in the tech industry. 

Here’s an example:

Your company grants you 10,000 ISOs with a strike price of $1.00 per share. The current Fair Market Value (FMV) of the company stock is $9.00. This means you have the option to buy up to 10,000 shares of your company stock at $1.00 per share, which is actually worth $9.00 per share. What a bargain! Why wouldn’t you do that? 

Incentive Stock Options (ISOs) at a public company

If, in fact, your company is publicly traded (i.e. anyone can buy the company stock), then you can turn right around and sell this stock for the $9 fair market value. You will be taxed on what is called the bargain element, which is the difference between the strike price and the fair market value. Note: the bargain element is a preference item under the AMT calculation. More on that below.

Incentive Stock Options (ISOs) at a private company

However, if you work for a private company (your company stock is not traded on a public market, like the New York Stock Exchange, it’s more complicated. You can buy those options, but more than likely you will not be able to sell them. So why would you do this? If you expect the value of the stock to increase and especially if the company might go public in the future, you are taking advantage of potentially lower tax rates on the growth of that stock.

That said, this is a highly risky proposition with regards to private company stock. If the company does NOT go public, you may have paid money to exercise stock which is ultimately worthless. 

What about taxes? And what is this dreaded AMT?

The trickiest part of working with ISOs is the tax implications. In particular, when you exercise ISOs, that triggers something called AMT or alternative minimum tax. AMT has been known to cause absolute panic in otherwise level-headed people. It’s not really all that scary, but many have been instructed to avoid “triggering” AMT at all costs. 

As referenced above, when you exercise ISOs, there is no tax due under the normal tax structure, but you will be taxed on the bargain element under the AMT structure. This only impacts you if you exercise ISOs in one tax year but do not sell them in that year. If you exercise and sell in the same calendar year, there is NO AMT. Instead you will pay ordinary income tax on the bargain element. Clear as mud, right? The scenario where you exercise and sell in the same calendar year is considered a disqualifying disposition. It’s not the most advantageous from a tax perspective, but it’s very straightforward.

What is a qualifying disposition?

A qualifying disposition occurs when you sell your stock at least 2 years after it was granted and at least 1 year after it was exercised. If these two criteria have been met, then you will be taxed on any gain at the long term capital gains rate (typically 15% or 20%, depending on your income). You still owe AMT on the bargain element in this case, in the year of exercise.

Many people have strong feelings about holding stock options long enough to have a qualifying disposition. While this is definitely better from a tax perspective, it may not be the best choice for you. By holding your company stock for a full year, you are opening yourself up to potential volatility.

How do you decide what to do?

In addition to tax considerations, as mentioned above, if your company is private, you must decide how much of your money (if any) you are willing to risk by exercising. How much can you afford to lose? This is a complex question and must be considered in conjunction with your larger financial picture in mind.

Additional considerations include:

  • Where will you get the money used to exercise options?
  • How will you pay the AMT tax bill when you file your taxes?
  • What is the general outlook of the company? Are you confident in its long-term prospects?
  • There are additional concepts around leverage and dilution that may be relevant.
    • Leverage refers to the difference between an option with a strike price of $1 (and FMV of $9) as compared to an option with a strike price of $8.50 (and FMV of $9). Which one would you rather have
    • And the percentage of ownership that your shares represent can have an impact, especially as those shares are likely to be diluted if the company issues more shares to other parties.
  • Read your company’s stock plan agreement to look for things like “repurchase rights” and “early exercise” options. You’ll want to know as much as you can about both your rights and the company’s. 

The final word: ISOs ARE complicated and there are a lot of things to bear in mind. It is unfortunately easy to “make a mistake” and end up with a surprise tax bill. Consider working with a financial professional and/or a tax advisor to thoroughly understand the implications of any transaction. And do as much research as you possibly can to understand the restrictions in place from your company. Check out our Instagram Live for more conversation about ISOs.