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If you are one of the (lucky!) individuals who has Incentive Stock Options, you are probably concerned about your hefty AMT bill once you exercise, and probably when you sell, if your capital gains are high enough. There are some basic guidelines to know about to ease your mind, or at least assist you in planning for these transactions.
The fundamental difficulty with ISOs is that when the fair market value (FMV) is low, conventional wisdom says not to exercise, or buy, the stock from the company you’re working for, since you could lose all your capital if your company goes under or doesn’t go public. But when the fair market value is high, your company is doing well (presumably), and you could make a lot of money if you sell your stock. Unfortunately, in the latter case, you might be subject to the AMT since the difference between the FMV and your exercise price is taxable under AMT rules.
If you would like to exercise your stock but either don’t have the capital to actually make the payment to your company, or don’t have the money to pay the AMT bill, or both, consider speaking to a local bank, preferably a regional bank that may not have as strict rules as a large multinational bank, about lending you the money for your transaction. If you can line up a buyer, or if your company is already publicly traded, the bank’s risk is substantially lowered, since they could require you to have an offer letter from a buyer before you even exercise, thus almost guaranteeing return of their investment.
If you are particularly worried about your AMT bill, you will probably need to sell your shares in the same year that you exercise. That way you won’t be on the hook for the AMT for one or more years until you sell the shares and can recoup some of your taxes that you paid upfront (If you are in this situation, be sure to file IRS form 8801 for the AMT credit for every subsequent year after you pay the AMT on the exercise of stock options in order to claim the credit in future years. Keep in mind you can only claim this credit in a year when you aren’t subject to the AMT.). The downside of this strategy is that you will have to pay short-term capital gains tax, which is much higher than long-term capital gains. However, this is typically thought of as the least riskiest route to take, since you know when you exercise that you will be able to sell the shares for a profit.
However, if you have nerves of steel, along with time and money on your hands, exercise early when your stock’s FMV is low! This is risky, as I mentioned before, since you could lose all of your investment, along with your job, if your company goes under. However, if you’re working at a startup, you probably already have a higher than average risk tolerance and may be the ideal type of investor to take on this risk.
Good luck, and be sure to consult a tax professional if you have exercised ISOs and need to determine your tax liability related to these types of transactions.