HOW INCENTIVE STOCK OPTIONS (ISOs) CAN QUALIFY FOR SPECIAL TAX BENEFITS

Do incentive stock options complicate your tax return? It depends.

Incentive stock options (ISOs) can qualify for special tax benefits under the tax code (if certain requirements are met):

- The employer can structure compensation to an employee that is not subject to Social Security or Medicare taxes
- The employee gets favorable long-term capital gains tax rates when they sell their exercised ISO stock

In order to receive those full benefits, an employee would need to hold the acquired stock for at least two years from when the stock options were granted, and one year from date the stock options were exercised.

An employee exercises their stock options by purchasing stock at the agreed upon price (strike price), which effectively results in a discount (known as the bargain element) on the company's stock (assuming the fair market value at that date is higher than the strike price).

Bargain Element = Fair Market Value - Strike Price

While the exercise of ISOs does not result in regular income tax due, the cumulative bargain element may trigger a separate tax calculation known as the alternative minimum tax (AMT) on the employee's tax return if the shares are not sold in the same year.

Given that employees are incentivized to hold onto their shares for a year after their exercise date, an employee that exercises their stock options and holds their stock in the exercise year would need an AMT calculation. While the calculation is necessary, there are factors beyond ISOs that can determine whether or not AMT tax is owed.

TLDR: Beware of the AMT--the tax code incentivizes holding your stock from exercised ISOs for a year beyond the exercise date, which could result in AMT tax owed for that year. If you exercised ISOs and held your stock, you may need an AMT calculation on your return.

As always, the best way to make sure your tax strategy is getting you the maximum after-tax dollars possible is to work with a CPA who is familiar with these nuances.

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