This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, November 12, 2000.
Part 1 of a 2-part series
As part of his compensation package with Acme.com, on January 1, 1999, Joe received 25,000 incentive stock options (ISO) and 20,000 non-qualified stock options (Non-Quals), along with an annual salary of $100,000. [See sidebar for description of terms.] Joe is single and rents an apartment. On May 2, 2000, Joe exercised 10,000 ISO when Acme.coms stock was trading at $100/share. The stock is now worth $30/share.
Question: Should Joe be concerned with taxes in 2000, even though he has not sold any Acme.com stock, and if so what is his tax bite?
Answer: Joe could have a very high tax bill. The moment he exercises any of his ISOs, a potential Alternative Minimum Tax (AMT) liability is triggered on the difference between what he paid and what the stock is worth on the date of exercise. In addition, no money is withheld by Joes employer to help pay for his pending tax on the stock, so he had better be prepared with cash on hand by April 15, 2001.
Once you exercise ISOs, you cause a taxable event and you could pay AMT on the stock received. So, whether the value of his stock increases or decreases from that date forward, Joe could owe the AMT on the stocks value on the date he exercised his options.
When Joe exercised 10,000 ISOs in May, he generated a $1 million paper gain (10,000 shares x $100/share = $1 million) even though he did not sell any shares. This gain is not reported under the regular tax system, but is considered a "tax preference" item under the murky AMT, a shadow tax system, activated when a taxpayer has tax preference items over a certain threshold. In Joes case, the federal AMT is $281,000 and the California AMT is $69,500 for a combined tax of $350,500. The tax is payable April 15, 2001, even through the share price of Acme.com has dropped 70% from the exercise date of May 2, 2000 and is now worth only $300,000.
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