Understanding employee stock options
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Incentive stock options
Incentive stock options

"There aren't many issues about stock options that aren't confusing to people," says Corey Rosen, executive director of The National Center for Employee Ownership. "Companies don't do a very good job of explaining the tax consequences, exercise methods and so on. For fairly sophisticated employees it may not be a big deal, but most people don't even know what AMT is, much less how to file it or how to plan around it."

Here's how ISOs work: Let's say you have 500 vested shares with an exercise price of $15. The fair market value on the day you exercise is $25. You buy the shares from the company by paying $15 per share and the shares are then transferred to an account in your name. Sell those shares in less than one year and you will pay your ordinary income tax rate on the difference between the exercise price and the fair market value of the stock at the time of exercise, and you'll pay short-term capital gains on any appreciation beyond the fair market value of the shares on the day you exercised the option. In other words, you'll pay your ordinary income tax rate on any gain above the exercise price. By selling the shares in less than a year you disqualify the option, and it no longer qualifies for favorable tax treatment.

Hold the stock for more than a year and you'll pay the long-term 15 percent capital gains tax on any appreciation above the $15 exercise price.

But here's the rub: There's a trap that comes with incentive stock options. Even if you plan to hold the shares for more than a year you still might owe AMT, and if the market takes a dive you could owe tax on money you no longer have.

"We're dealing with two different tax systems that work parallel to each other -- the regular tax and the AMT," says Thomas. "Under the regular tax you don't have any income to report when exercising an ISO and if you hold long enough you'll have long-term capital gains and completely avoid having to pay any ordinary tax.

"But under the AMT system, the ISO is treated pretty much the same as nonqualified stock options under the regular tax system. When you exercise the option you have income under the AMT system even if you don't sell the shares."

Let's use an example of exercising options that have a profit of $25,000. Sell the stock right away and you have disqualified the option; you'll pay ordinary income tax on the gain.

If you exercise and hold the stock, you don't have any income to report under regular income tax, but you have $25,000 in compensation under the AMT. Using the AMT tax rate of 26 percent for taxable AMT income of $175,000 or less, 28 percent for any amount above that, you'll owe $6,500 even though you didn't sell any shares.

If you hold the stock and the share price tanks, bringing your profit down to $12,000, the IRS will still expect $6,500 in taxes.