The Congressional Research Service recently released its report on the tax issues surrounding employee stock options, including the impact of the Alternative Minimum Tax. As noted in the report, over 10 million employees currently receive stock options as a form of compensation from their employers. With this significant a portion of the U.S. population being faced with the complexities of the taxation of stock options, a review of the Regular Tax and Alternative Minimum Tax treatment is essential to basic tax planning for those affected.
Congressional Research Service (CRS)
The CRS is an agency of the U.S. Government, located within the Library of Congress. Its purpose is to provide politically neutral legal and policy analysis to Members of both the House and the Senate. Its reports provide straightforward and objective analyses of important legal issues.
What is a stock option?
A stock option simply is a right, granted by an employer to an employee, to buy a certain number of shares of the employer’s stock at a set price. If the stock goes up in value the employee receives additional compensation in the form of the appreciation in the stock’s price. For example, if Employer A grants Employee X the right to buy 1,000 shares of stock at $10 per share, and the stock price goes to $15 when the employee exercises the option, the individual will have received additional compensation, over and above his or her base salary, in the amount of $5,000.
Two types of employee stock options
There are only two basic types of employee stock options – “qualified” and “nonqualified.” Because qualified options must meet certain requirements in order to be labeled as such, and they have less favorable tax results for the issuing employers, these are less frequently encountered. Nonqualified options, on the other hand, are easier to issue because of the lack of these requirements, and along with the more favorable tax treatment to the employer, are more commonly found. The Alternative Minimum Tax treatment is significantly different between these two types of options, so it is very important as a first step that the employee know which type of option he or she has received.
Qualified stock options
Qualified stock options are also known by their Internal Revenue Code label “Incentive Stock Options,” or “ISOs.” Employees prefer receiving these because there is no tax due on the date of exercise for Regular Tax purposes. So long as certain holding period requirements are met, the employee will have long-term capital gain treatment on subsequent sale of these shares, resulting in a significant tax savings because the capital gains tax rate is much lower than the tax rate on ordinary income.
Nonqualified stock options
The Regular Tax treatment of nonqualified stock options is much different than it is for ISOs. For this type of option, on the date of exercise the employee will have compensation income, reported on his or her W-2, for the increase in the value of the stock. In addition to the Regular Tax rates applying (currently as high as 35%), FICA taxes also will be due.
Example – comparison of Regular Tax treatment
Using the above example of $5 of appreciation on 1,000 options, the tax savings alone from exercising an ISO as compared to a nonqualifed option could be nearly $1,400, a very significant part of the total $5,000 gain. This represents the difference between a capital gains rate of 15% applying and an ordinary income rate of as high as 42.65% (35% income tax and 7.65% FICA tax).
Alternative Minimum Tax
Because the AMT was designed to put a damper on some of the favorable Regular Tax treatments found in the tax law, there is a price to be paid by those exercising ISOs. While there is no Regular Tax to be paid on exercise of an ISO, the “spread” (the $5 in our example) per share is a tax preference item, and must be included in the employee’s AMT income (“AMTI”). By including this amount, the employee’s AMTI will be higher than his or her Regular Tax, thus potentially triggering the AMT in the year of exercise.
AMT planning for ISOs
The planning to minimize – and in many cases to completely eliminate – the AMT impact from exercise of ISOs is fairly easy. All one has to do is a little planning before the exercise, testing for the AMT using alternative amounts of ISO shares. For example, it could be that the $5,000 in our example is not enough of a tax preference item to trigger the AMT, while exercising several years’ worth of options at once would trigger the AMT. In this case, the employee is better off spreading the exercise over several years instead of doing them all in one year.
There are 10 million people out there who can do just two simple things to avoid unnecessarily paying the Alternative Minimum Tax. The first is to understand what kind of option – ISO or nonqualified – he or she has. The second, assuming it is an ISO, is to calculate the AMT impact from the exercise of different amounts of options, and then to select the amount that avoids the AMT. It’s simple and easy to do, and the result could be saving thousands of dollars of taxes.