Tax Savings Expand For Some Stock Options

(Dow Jones) Incentive stock options will soon become more attractive for some executives because of greater tax savings they will offer. Ironically, higher tax rates next year are the key.

Options holders will be able to leverage the difference between alternative minimum tax rates, which will stay stable in 2011, and rates on ordinary income and capital gains, which are set to rise. Some stand to nearly double their tax savings this way.

Kaye Thomas, publisher of the tax advice website Fairmark.com and author of the book Consider Your Options, said that "many" ISO holders will be affected. He plans to publish an analysis of the topic next week.

Employers have been granting more options over the past year and a half as stock prices have slumped, according to Aaron Boyd, head of research at Equilar, an executive compensation research firm. The upswing follows a general contraction earlier this decade: After companies were required to expense options in 2003, they shifted more toward granting restricted stock.

Nonetheless, many financial advisors and employers do not make the AMT implications of options clear to employees who get them, said Emily Cervino, director of the Certified Equity Professional Institute at Santa Clara University, which trains people who administer stock compensation plans. The AMT is at the heart of ISO planning because it is triggered when a person exercises an option and holds the shares instead of selling them.

The AMT is a separate set of rules that figure the minimum tax due in a specific bracket; if that is more than one would pay under the regular income tax, one pays the AMT to make up the difference. The AMT tax rate, 28% for those who earn above $175,000, is not set to change when the Bush tax cuts sunset in 2011. Ordinary income rates, however, will rise to 39.6%, and long-term capital gains to 20%. A caveat: the AMT is one of the most complicated parts of the tax code, and various exemptions and phase-outs apply.

Executives with ISOs are likely to be among those with income in the low six figures. Often, they are either paying a few thousand dollars of AMT or in a position where it wouldn't take much to move them into it. (In other words, the tax they calculate under AMT is roughly equal to their regular income tax.)

An example, provided by Thomas, is a person who would owe $40,000 in regular income tax and $43,000 in AMT. He exercises an ISO with a profit of $1 million and holds all the shares. Because he does not sell, his regular income tax is not affected. However, his tax goes up by about $280,000 under the AMT rules.

The next year, he sells the shares for $1 million profit, generating a capital gain that is taxable under the regular income tax but not under the AMT. He can claim an AMT credit roughly equal to the amount of tax on the capital gain, eliminating tax on the sale (except to the extent that the stock rose in value after he exercised). The only tax that matters is the AMT he paid in the year of exercise, which was $280,000.

So, the profit from exercising the ISO was taxed at 28%, rather than the regular income tax rate of 35% this year or 39.6% next year. At today's top rate of 35%, the tax saved is 7 percentage points. When the top rate goes to 39.6% next year, according to Thomas, the same ISO will save 11.6 percentage points.

A potential hitch: The $280,000, while a tax savings, is also still a big bill. Paying it may not present a problem for an informed executive who has resources. Not so for uninformed employees who might have thought to pay the bill by selling the shares. For them, it could be a "disaster," said Cervino.

Indeed, Thomas does not ordinarily recommend holding all the shares after exercising an ISO with such a large built-in profit. Many option holders can sell as many as half the shares or more immediately after exercising without sacrificing tax benefits.