At Gedeon Law & CPA, we deal with a lot of clients who are issued Incentive Stock Options (ISO) by their employers.
Recently, one of our client’s who works at a well known video game developer contacted us about exercising some of her ISO. The company’s shares are currently valued at $100/share. She has 100,000 options that were granted to her at a $0.10 exercise price three years ago.
As you can imagine, our client is jumping for joy because she is worth, on paper at least, $10 million.
In the midst of planning her early retirement to a palatial villa in Tahiti, our client contacted us to share the good news.
After congratulating our client, we advised her that she may want to put her early retirement plans on hold.
Why? Because unless our client holds the shares for at least one year after exercising the shares and at least two years from the date the options were granted, she won’t be able to take advantage of the lower long term capital gains rates. Instead, the sale of the shares will be taxed as ordinary income at, in our client’s case, the highest federal tax rate (40%).
But of course, it gets worse. Before our client even sells a single share, the mere fact she exercised all the ISO means she owes Uncle Sam $2.8 million thanks to the 28% Alternative Minimum Tax(AMT). While she doesn’t have to pay regular income tax on the exercise of the ISO, she will need to pay the AMT on the difference between the exercise price and the fair market value of the shares at the time of exercise.
How can she cover the $2.8 million AMT tax bill? Simple, she has to sell some of the shares she exercised. But as we mentioned before, the taxable income from the shares she sells will be taxed as ordinary income at a rate higher than 28%.
Could our client’s dreams of early retirement be shattered even more? Of course they can.
Say the value of her company’s stock drops to $1 because her employer’s latest video game release failed to sell. Well, our client is still subject to $2.8 million in taxes from the AMT and, even if she sold all the shares, she would not be able generate enough cash to cover the AMT bill.
As you can see, dealing with ISO can be tricky.
At Gedeon Law & CPA, our tax professionals are available to assist you with evaluating the tax impact of exercising stock options.
