Tax planning and compliance for investors
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Tax rules that apply when you exercise an incentive stock option.
One of the key differences between incentive stock options (ISOs) and nonqualified stock options is that you don't have to report compensation income when you exercise an ISO. But you may have to pay a significant amount of tax anyway, because of the alternative minimum tax (AMT).
The description on this page assumes you're using cash (not stock) to exercise your ISO, and that you'll hold the stock for some time, rather than sell it immediately. Later pages deal with the tax consequences of cashless exercise, exercise using stock you already own, and disposition of stock you acquired using an ISO.
For purposes of the regular income tax, the exercise of an incentive stock option is a non-event. There is no tax — in fact, nothing to report on your tax return — when you exercise an ISO. This is dramatically different from the treatment of nonqualified options. Generally you report compensation income equal to the difference between the fair market value of the stock and the amount paid under the option when you exercise a nonqualified option.
Because you don't report any income when you exercise an ISO, your basis for the stock you acquired is simply the amount you paid for it. Your holding period begins on the day you acquire the stock: you can't include the period for which you held the option.
So much for the good news. The bad news is that the exercise of an incentive stock option gives rise to an "adjustment" under the alternative minimum tax. The adjustment is precisely the amount you would have reported as compensation income if you exercised a nonqualified option instead of an ISO. In other words, it's equal to the amount by which the fair market value of the stock exceeds the amount you paid for it (otherwise known as the spread or the bargain element). For details see Exercise of Nonqualified Stock Options.
The AMT adjustment has three consequences. First and most obviously, you may have to pay AMT in the year you exercise an incentive stock option. There's no way to determine the amount of AMT you'll pay simply by looking at the amount of the bargain element when you exercised your option. The bargain element on your exercise of an ISO may be the event that triggers AMT liability, but the amount of liability depends on many other aspects of your individual income tax return. You may find that you can exercise some ISOs without paying any AMT at all. If your bargain element is large, you should expect to pay AMT as large as 28% or more of the bargain element. (The maximum rate for the AMT is 28%, but the tax resulting from a single large item can be greater than that percentage because of the interaction of various features of the alternative minimum tax.)
The second consequence from the AMT adjustment is that some or all of your AMT liability will be eligible for use as a credit in future years. This credit can only be used in years when you don't pay AMT. It's called the AMT credit, but it reduces your regular tax, not your AMT. In the best case, the AMT credit will eventually permit you to recover all of the AMT you paid in the year you exercised your incentive stock option. When that happens, the only effect of the AMT was to make you pay tax sooner, not to make you pay more tax than you would have paid. But for various reasons you can't count on being able to recover all of the AMT in later years.
The third consequence of the AMT adjustment is very important — and easy to overlook. We noted earlier that the stock you acquire when you exercise an ISO has a basis equal to the amount you paid. But the stock has a different basis for purposes of the alternative minimum tax. The stock's AMT basis is equal to the amount you paid plus the amount of the AMT adjustment. That means you'll report a smaller amount of gain for AMT purposes when you sell the stock.
Example: You exercise an ISO, paying $35 per share when the value is $62 per share. You report an AMT adjustment of $27 per share. Later, after satisfying the ISO holding period, you sell the stock for $80 per share. For purposes of the regular income tax you report gain of $45 per share ($80 minus $35). But for AMT purposes you report gain of only $18 per share. Your AMT basis is equal to the $35 you paid plus the $27 adjustment you reported.
The difference in the amount of gain reported can help you avoid paying AMT on other ISOs you exercise in the same year you sell this stock — or it can help you take advantage of the AMT credit described above. If you overlook the higher AMT basis of this stock you may end up unnecessarily paying double tax with respect to your ISO.
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