There are two types of stock options: qualified and non-qualified. Qualified options are also referred to as incentive stock options (ISOs). For non-qualified options, the difference between the stock’s exercise price and its fair market value (FMV) is treated as ordinary income; for employees, this difference is generally is included as income on their W-2s. No alternative minimum tax (AMT) preference income results from exercising a non-qualified stock option.
On the other hand, ISOs receive special tax treatment that permits delayed taxation on the difference between the exercise price and the FMV; this gives the employee the benefit of long-term capital gains rates when the stock is ultimately sold—provided that the stock is not sold until at least 2 years after the option was granted and at least 1 year after the option was exercised.
However, the downside of ISOs is that the difference between the stock’s exercise price and its FMV, although not taxable for regular tax purposes, is included in AMT income in the year the option is exercised. When the stock has a significant difference between exercise price and FMV, the AMT will trigger. Although this will create an AMT tax credit to carry forward, that credit is only beneficial in years when the taxpayer must pay an AMT.
Therefore, it may be appropriate to avoid the AMT in the year an ISO is exercised by selling the stock in the same year. Doing so will cause the difference between the stock’s exercise price and its FMV to be treated as ordinary income; that income will be the same for regular and AMT purposes, eliminating the AMT preference for the year. The decision about whether to sell the stock in the year it is exercised or to hold it for long-term capital gains rates requires careful analysis.
Alternatively, when doing so is beneficial, the taxpayer can exercise the option in small blocks over a period of years, thus both avoiding or minimizing the AMT and taking advantage of long-term capital gains rates.