If I convert ISO stock options to stock & hold them for a year, will it affect AMT in the year I do it?

Question

These stock options are ISOs, which are presumably tax free, so long as I convert the options to stock and hold ALL of the converted stock for a minimum of one year. I don't know however if I will be affected by AMT in the year I convert. Also since the options terminate in January 08, would it be wise to convert them in thirds; one-third this year, a third next and the final third in 08?

Answer 1

There is no “regular” tax implication when exercising stock options. The regular tax kicks in when you sell the stock.

If the stock is sold more than 1 year after it was exercised AND more than 2 years after it was granted, then the gain from the grant date to the sell date is all capital gains.

If the stock is sold 1 year or less after it was exercised OR 2 years or less after it was granted, then the gain from the grant price to the Fair Market Value (FMV) when it was exercised is considered ordinary income not subject to FICA. The remaining gain/loss is capital gain. It is long term if the stock was held more than one year after it was exercised.

AMT:

Alternative Minimum Tax is different in that the exercise event DOES trigger tax. The built-in gain from the grant date to the FMV at the exercise date is added to your AMT income. When the stock is eventually sold, you will do two Schedule Ds...one for Regular Tax with the basis equal to the grant date price, and one for AMT with the basis equal to the FMV price. Your regular gain will be larger than your AMT gain because your AMT basis will be larger.....you've already paid tax on some of your AMT gain whereas you didn't pay any regular tax on this gain. Confusing, isn't it.

Will you definitely have AMT when you exercise ISO stock? Not necessarily. Your AMT will be affected, but will it grow to the point where it will be higher than your regular tax? It depends on other items on your return. To get an idea of how much you can absorb, go back to your 2005 tax return and figure out your AMT and see how far it was below your regular tax. This is an estimate of 2006, not a guarantee.

If ISO exercise does cause your AMT to be larger than your regular tax, of course, you will have to add the difference to your regular tax as you expect. However, unlike other things that trigger AMT, ISO exercising is refundable. What? You get a credit for whatever additional tax you have to pay due to ISO exercising. This credit carries forward to next year and, if not used up, carries forward to the next year. It keeps doing this until it is used up. This credit goes against regular tax until it drops to your AMT tax.

Comprehensive example:

2006: Your normal regular tax is $20,000. Your AMT is $16,000. You exercise 10,000 shares with a FMV of $10/share with a grant price of $4/share. You have to add 10,000 x (10 - 4) = 60,000 to your AMT income causing, let's say, $15,600 of additional AMT tax. AMT is now $31,600 which is $11,600 more than your regular tax. So, for 2006, your tax liability is $31,600, however, you get a credit of $11,600.

If in 2007, your regular tax is still $20,000 and your AMT is still $16,000, your tax is $16,000. $4,000 of credit was used to lower your regular tax down to your AMT. Your credit now drops to $7,600.

If in 2008 you sell the stock for $20, your regular gain is 10,000 x ($20 - $4) = $160,000. Your AMT is 10,000 x ($20 - $10) = $100,000. Again, you figure out your regular tax and AMT and if the AMT is lower than your regular tax, you get to use the carry-over credit until it is used up.

Of course, part of your basis is your brokerage fees, but to keep things simple, I ignored these. If you sell at a regular loss or even at an AMT loss, the rules still apply, but you can only get $3,000 per year of loss to use against other income.

Hope this helps :)