ISOs in a down market.

In this time of tight labor markets, many companies offer incentive stock options (ISOs) to attract and retain talent. Before the decline in the stock market this spring, many employees had large paper gains after they exercised these options. Traditional tax planning has tried to find solutions for taxpayers who own stock worth significantly more than an ISO exercise price. But what about the employee who exercised ISO stock before the March/April correction and still holds it? This investor/employee may have the worst of two worlds: alternative minimum tax (AMT) to pay on April 15, 2001, and stock that has decreased in value. Although there is no "alternate valuation" date for ISO stock, there may be a way for employees to escape from this situation.

ISOs

ISOs offer two tax benefits. First, an employee can convert ordinary income into capital gain income. Second, the employee enjoys economic income by buying stock at a bargain price, but defers the tax liability until the stock is sold.

An ISO grants employees a right to buy stock at market price on the option's grant date. To enjoy tax benefits, an employee must not sell his stock before the earlier of two years after the option's grant date or one year after exercise.

Example: Employee T exercised an option to buy 10,000 shares of a publicly traded stock for $5. The stock was worth $55 on the exercise date, but a market correction has reduced the stock price to $10.

Regular Tax Rules

For regular tax purposes, ISOs do not result in taxable income on the option grant date or when an employee exercises the option (Sec. 421). There is no reporting requirement. Basis is the cash price paid and the capital gain holding period begins to run on the exercise date. As long as the option holder owns the stock for the required holding period, the stock is a capital asset that can give rise to capital gains. If the employee sells the stock before the end of the required holding period, any income is ordinary (compensation) income.

AMT

Although the exercise of an ISO does not create taxable income, it does create income for AMT purposes. The additional AMT income is the difference between fair market value (FMV) and the exercise price, multiplied by the number of exercised shares.

In the example, T would have $50,000 of additional AMT income. This can be a big problem, particularly for an employee whose AMT income is in the AMT exemption phaseout range (i.e., between $150,000 and $330,000 for a married individual filing jointly). The effective AMT rate is 35% for taxpayers in that range; every $4 of additional alternative minimum taxable income (AMTI) means $5 of additional taxable AMTI and $1.40 of additional tentative AMT.

The good news is that an AMT credit will be available if a shareholder pays AMT. In addition, the ISO stock will have a higher basis for AMT purposes, so an adjustment is available on Form 6251, Alternative Minimum Tax--Individuals. These "benefits" are a small consolation compared to paying $17,500 of AMT on stock worth less now than when T exercised the ISO.

Proposed Solution

Traditional ISO planning assumes that stock prices are stable or rising. As some of last year's dot-com millionaires learned this spring, that is not always the case. When ISO stock falls dramatically, the solution is to sell the stock. The interaction of Secs. 56(b)(3) and 422(c)(2) offers a unique planning opportunity.

When an ISO is disposed of in the same year it is exercised and the amount realized is less than the stock's FMV at the time of exercise, the amount includible in AMTI shall not exceed the amount realized on the stock's sale or exchange, less the taxpayer's basis. Under Sec. 56(b)(3), Sec. 422(c)(2) applies if ISO stock is bought and sold in the same year. Under Sec. 422(c)(2), the amount that an individual must include in income when ISO stock is bought and sold in the same year "shall not exceed the excess (if any) of the amount realized on such sale or exchange over the adjusted basis of [the ISO stock]." The sale is a disqualifying disposition. However, because the gain is based on the amount realized on the sale (and not on the value of the stock on the ISO exercise date), the AMT adjustment does not apply.

If, in the example, T sells the ISO shares for $10, there will be $5,000 of ordinary income. The Federal income tax cost is limited to $2,000 (and probably less for most taxpayers).

In addition, as long as the ISO stock is sold for a profit, the wash-sale rules will not apply. If the shareholder is confident the stock will rebound in the future, he can buy stock in the company after selling the ISO stock. For example, after selling the ISO shares for $10 per share and recognizing $5,000 of income, T can repurchase the stock for $10 and hold it. After a year, the long-term capital gain rates will apply, but without the current cost of paying AMT.

Summary

An employee who exercises ISO stock when a company is a market favorite, but owns the stock after a market downturn, may be better off selling the stock early. A disqualifying disposition could result in lower tax and increased cashflow. This is a better outcome than owning ISO shares and facing a big tax bill.

FROM KENT BUSEK, CPA, MBT, EIDE BAILLY LLP, FARGO, ND (NOT ASSOCIATED WITH AFAI)