Tax Implications of Employee Stock OptionsMay 23, 2012. Start-up companies, particularly in high tech fields, hire and retain employees by awarding incentive stock options (ISOs). Everyone knows that that is one way that tech start up’s encourage strong employee performance; in fact, many people work for startups specifically for the stock option opportunity. This is all the more true in the San Francisco Bay Area, as we are a hotbed of start up and IPO activity!


If you are receiving stock options here in the San Francisco Bay Area, please email our office for a free phone consult, or just call us at 415.742.4249.


What is not so well known, however, is the careful tax planning required to minimize taxes and to avoid some tax traps usually unexpected by employees of start up’s. A particularly stinging tax hazard for employees of rapidly growing companies is the alternative minimum tax or AMT that may be imposed on the sale of appreciated employer stock acquired through the exercise of their ISOs.


How do employee stock options, or more formally incentive stock options work in terms of taxes? Here is a quick explanation. First, no income tax occurs when an ISO is granted. In addition, there is no income tax due when the incentive stock option is exercised. The first taxable event occurs at the sale of shares acquired by exercise of an ISO. At that time, the employee recognizes taxable gain equal to the difference between the sale proceeds and the option price (the price the employee paid on exercising the option). If holding period requirements are met, this gain is capital gain. To obtain favorable long-term capital gain tax treatment, stock acquired under an ISO may not be sold before the later of two years from the date of grant of the option, or one year from the date of exercise of the option.


The Alternative Minimum Tax


Second, there is a tax gottcha in the form of the alternative minimum tax or AMT.
The Emergency Economic Stabilization Act of 2008 abated AMT liability stemming from the exercise of incentive stock options (ISOs) before 2008. Interest and penalties on the unpaid amounts were also abated. The more rapidly the underlying stock appreciates, the greater the risk the employee will owe alternative minimum tax (AMT) on the exercise of the option. This is because alternative minimum taxable income (AMTI) is calculated by including the difference between the fair market value of the stock on the date the incentive stock option is exercised and the option price paid (the “ISO spread”). The employee calculates both regular and alternative minimum income tax for the year; the higher of the two will be the amount due.
What’s worse is that the employee who incurs AMT may have to pay it from funds other than proceeds of sale of the stock. This could occur if the stock is sold in a tax year later than the year the option is exercised. It could also be necessary if the price of the stock drops and is below its exercise price when it is sold. This risk of phantom AMT makes tax planning crucial!


Although the AMT is a significant concern, tax planning should not focus solely on eliminating AMT liability. Due to the complexity of the interrelationship of the AMT and regular tax systems, concentration on lowering minimum tax liability alone could easily result in an unwanted increase in your regular income tax liability.


How best to Handle Stock Options and the AMT


In general, the best way to handle AMT liability is careful planning involving the coordination of future regular income tax and AMT, using accurate projections of income, expenses, and deductions over multiple years with several alternative scenarios. An overall plan must then be devised to manage your AMT liability without raising regular tax liability.


Now, everyone’s situation is unique. Let’s say you work at an established Bay Area company like Intel and receive stock options as part of your compensation. That’s quite different than working at Twitter here in San Francisco, which has yet to go public, or at LinkedIn or Facebook which have gone public but may still have restrictions on how much stock you get and whether you can sell. In addition, your current and future compensation may vary depending on whether you are in management, technical, or marketing. Everyone’s situation is different; indeed, if you are married, you also have to factor in your spouse’s income vs. exercising and/or selling your start up stock. So even in the San Francisco Bay Area, it’s not one size fits all with respect to stock options and compensation! That’s why it’s best to work with an expert CPA firm on these issues.


As a San Francisco-based CPA firm, we believe that a thorough analysis of your current and projected tax situation could minimize or eliminate your exposure to AMT liability. Please email our office for a free phone consult, or just call us at 415.742.4249. Mention this blog post when you contact us.