Incentive Stock Options and the AMT

From a tax perspective, incentive stock options (ISOs) are an advantageous form of compensation. Such options do not create regular tax consequences either on the date of grant or the date of exercise as long as the holding period and some additional requirements are met. However, as discussed in text Section 12-2a, the difference between the fair market value and the exercise price of an ISO creates an AMT adjustment in the year of exercise.

The AMT adjustment for this difference (i.e., the bargain element) is required unless a taxpayer sells the shares acquired with the ISO in the year of exercise. This is known as a disqualifying disposition. Where the price of the stock acquired with the ISO has declined since the exercise of the option, a disqualifying disposition is usually a good idea. For example, assume that a taxpayer exercises an ISO to purchase 500 shares of her employer’s stock in March. The exercise price is $10, and the fair market value on the date of exercise is $50. Thus, the exercise of the ISO creates an AMT adjustment of $20,000 [($50 − $10) × 500] for that year. If by the end of the year the stock’s value has declined to $16, the AMT adjustment will still be required even though the shares have declined in value and the taxpayer may not be confident that their value will increase over time. Thus, it would make sense for the taxpayer to make a disqualifying disposition before the end of the year, avoid the AMT adjustment, and pay (regular) tax on compensation income. In this example, the taxable amount would be $3,000 [($16 − $10) × 500 shares)].

However, where the stock’s price increases in value in the year of exercise, a disqualifying disposition is usually best avoided. That is, in the example above, assume that the fair market value of the stock had increased to $65 near the end of the year. The AMT adjustment would be unchanged. Assuming that the taxpayer was in AMT, this adjustment would generate an AMT liability of $5,200 [$20,000 adjustment × 26% AMT rate]. A disqualifying disposition in that year would eliminate the necessity of the AMT adjustment but would trigger regular tax consequences. In this example, the taxpayer would have compensation income of $20,000 [($50 − $10) × 500] plus a short-term capital gain of $7,500 [($65 − $50) × 500]. As long as the taxpayer is in a regular tax bracket above the 26 percent or 28 percent AMT rates, the AMT adjustment has a lower tax cost than a disqualifying disposition.

Two additional considerations can be used to evaluate the above analysis. 

First, in the case where the stock’s price increased after exercise, what if the taxpayer was leery of holding on to the stock acquired with the ISO because of concern that the employer’s stock price would decline in value over time, perhaps due to some inside information the employee holds? Should a disqualifying disposition be made in that situation? 

Second, in the case where the stock’s price declined after exercise, how do they increase in the AMT exemption and phaseout amounts affect the decision to undertake a disqualifying disposition?