Incentive Stock Option Taxation & the AMT - The Dallas Morning News, 4/24/2014

http://dollarwiseblog.dallasnews.com/2014/04/incentive-stock-option-taxation-the-amt.html/

Question: A Dallas Morning News reader wrote in with background information about the exercise of stock options in a previous year and asking taxation questions pertaining to the exercise of those options and future year tax ramifications. Specific figures regarding their situation have been deleted, but their questions have been answered in the narrative below.

Answer: As equity compensation slowly makes a comeback after the 2000 Technology Stock Market Bubble, your questions are an excellent reminder for understanding the ins and outs of Incentive Stock Options (ISOs).

Specifically, you stated that in early 2012 you exercised ISOs and held the shares of stock. To date, you continue to hold these same shares of stock. When preparing your 2012 tax return during the first quarter of 2013, you found out that you owed a considerable amount of tax due to this stock option exercise. This is because Alternative Minimum Tax (AMT) rules treat you as if you exercised a nonqualified stock option if you hold ISO shares after the end of the year you exercise the option. In other words, the bargain element (difference between the fair market value at date of exercise less the exercise price) of the options is taxed in the year of exercise (even if you continue to hold the shares of stock) in AMT calculations. In your case, since the bargain element was a substantial amount, you owed AMT tax liability over and above your regular income tax liability.

The following tax year, your 2013 tax return had no Alternative Minimum Tax owed. You were able to reduce your 2013 regular income tax due by some of the AMT Credit created by the 2012 AMT tax paid; however, you continue to have a considerable AMT Credit carry forward due to the initial AMT tax paid on your 2012 tax return.

As experienced with your 2013 tax return, the AMT credit can reduce the amount of tax you pay in subsequent years, especially, but not exclusively in the year that you sell the ISO shares of stock. However, it is not uncommon for many taxpayers to never fully recover the entire amount of AMT credit generated after they sell the ISO shares of stock.

The AMT credit carry forward does not expire. So, if you created an AMT credit by exercising an ISO, you need to file Form 8801 in every subsequent year you file your tax return until the credit is used up. If this sounds like extra work, realize that it is extra work. However, filing Form 8801 every year is necessary to keep you from overpaying future taxes when you may be eligible to use the carry forward AMT credits.

Holding the ISO shares of stock past the calendar year end when you exercised the shares, also created the interesting characteristic of dual cost basis for your unsold shares of stock. For purposes of future tax calculations, you didn't report any income for exercising the option in the regular tax system, so the basis for the shares is the amount that you paid for the shares. Under future AMT tax calculations, you reported income on the shares in 2012, thus this compensation amount is added to your basis for the shares. In other words, your shares of stock have dual basis: one number for regular tax and a different number for AMT. When you sell the shares of stock, the amount of gain or loss produced will be different numbers under the regular tax and AMT tax calculations in the same tax year.

How could this entire situation have been avoided? Unfortunately, for you and many taxpayers in 2000, this situation could have been avoided by selling some or all of the ISO shares prior to the end of the year that you exercised the ISO shares. While individual tax situations vary, it may have been possible to sell many of the shares right away without giving up any overall tax benefit, yet you would have considerably reduced your investment risk. This special rule for ISO shares snagged you into paying AMT tax, even though you never sold the shares!

Here is my best advice. If you receive equity based compensation from your employer, congratulate yourself for a job well done and then immediately employ the services of a knowledgeable tax professional with experience in these issues. The extra cost of a seasoned professional should give you peace of mind and keep you out of harm's way from tax traps.

Best Wishes,

Trudy R. Turner CPA, CFP®

Financial Planning Association volunteer recommendations are for informational and educational purposes only. Please consult with your financial planner, CPA or attorney before taking action based on this information. The Financial Planning Association or the volunteers will not be held responsible for any action taken or mistakes posted.