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Watch out for a hidden tax trap accompanying ISOs

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Do you own stock acquired by exercising incentive stock options (ISOs) issued by your company? Those shares can reap big rewards if you hold on to them long enough to qualify for preferential tax treatment.

Warning: ISOs can also pose a tax trap: For purposes of the alternative minimum tax (AMT) calculation, you’ll realize a taxable gain when you exercise such options.

Worst of all, the gain is still taxable under the AMT even if the stock’s value drops while you’re holding it.

A taxpayer in a new case stepped right into this lethal trap. (Palahnuk, 127 TC No. 9)

First, here are the basic rules: Normally, you don’t owe any income tax when you exercise an ISO that your company grants to you. Furthermore, the IRS will treat your gain from selling the shares as long-term capital gain if you meet these requirements:

-You must hold the stock for more than one year after the option is exercised.

-You must sell the shares at least two years after the date on which the option was granted.

Currently, the maximum federal income-tax rate on long-term capital gains is only 15 percent, as opposed to ordinary-income rates reaching as high as 35 percent.

Facts of the new case: A taxpayer was granted ISOs in 1998 during the dot-com craze. In 2000, he exercised the ISOs and bought shares of company stock with a value of $2.1 million. He paid only $100,000 for the shares.

For purposes of his regular 2000 tax computation, the taxpayer realized no taxable income from exercising the ISOs. But he realized $2 million in 2006 income for AMT purposes.

By the time the taxpayer sold the shares in 2001, the market for the shares had collapsed. He received about $250,000 for the shares, representing a capital gain of $150,000 for regular-tax purposes. But the IRS said he still owed AMT on the $2 million gain for the 2000 tax year, when he exercised the ISOs: $1.75 million more than the shares’ value.

Bottom line: The taxpayer was stuck paying the full tax amount on the AMT gain in 2000.

This new case points out a major pitfall for taxpayers holding ISOs that might be declining in value. In this case, the taxpayer might have gotten much better results from selling in 2000, rather than in 2001.

Tip: Don’t jump in head-first when you think it’s a good time to exercise ISOs. Discuss the AMT impact with a tax pro.

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