As stock-based compensation has become more common, and as the stock market itself has soared, more and more employees find themselves having to deal with stock options from their employer. The value of the options can dwarf the salaries paid in many cases, so properly planning to deal with those options can be a major issue that most of us weren’t trained to handle.

How are options taxed? Well, in general, any difference between the price you pay for the stock (the option price) and the fair market value of the stock (the market price) is taxable as ordinary income to you at the date you exercise the option. However, if the option is of a special type known as an incentive stock option (ISO) there is no regular tax on that spread so long as certain holding periods are met. The spread, however, is considered taxable income for alternative minimum tax purposes.

This article deals with five common mistakes I’ve noticed that many employees make when dealing with employer granted stock options.

1. Avoiding the alternative minimum tax at all costs

Some of the options that employees receive are known as incentive stock options (ISOs). These options have some unusual features compared to other options (normally referred to as nonqualified options)—and perhaps the most infamous feature is that they can trigger liability for the "alternative minimum tax" on your tax return.

What is the alternative minimum tax (or AMT for short)? Actually, is a rather simplified tax system that allows far fewer deductions than the regular system does, but otherwise taxes income at a lower rate. Each year you effectively pay the higher of the alternative minimum tax or the regular tax. In many, but not all, cases when you pay alternative minimum tax, you receive a credit which can be used to reduce your regular tax down to the AMT level in future years.

Some people, misled by the way the 1040 form makes the AMT look like an additional tax, decide to avoid the AMT through means that serve only to increase their regular tax until it is higher than the AMT. Thus, they pay more tax than they otherwise would pay. A favorite way of doing that is to disqualify the option by failing to meet the required holding period, such as by cashing it in immediately.

It is important to note that when you take a disqualification step, all you’ve really done is left the AMT at the same level. The spread would have been taxed for AMT purposes anyway. However, by disqualifying the option you’ve increased the regular tax so that it is now higher than the AMT. As well, part of that AMT could have been recovered in future years through the AMT credit and the higher basis we have in the stock for AMT purposes.

The AMT credit is supposed to even out the affects of the AMT by allowing a credit down to the level of the AMT until we exhaust the credit in years when the regular tax is higher. Additionally, when the ISO stock is finally sold, we recognize a smaller gain for AMT purposes, which increases the difference between our AMT and our regular tax.

Disqualifying options is still a useful tool for managing the AMT, but it generally takes significant work to determine the optimal mix. Rarely will it be the case that all options exercised should be immediately disqualified in order to obtain the optimal tax result.

2. Delaying exercise of the options until the last minute

One of the first things most new tax planners learn is that, all things being equal, it is better to pay taxes later rather than sooner. Some employees, picking up on that theory, twist it to mean that you should always wait until the last possible moment to exercise any options. That means doing so in the year they are set to expire (perhaps even the precise day) or when the employee changes jobs.

The problem with that theory is that it ignores an important issue—different types of taxable income are taxed at different rates and the amount of tax paid at exercise will most often increase as the price of the stock goes up. This becomes especially a problem for shares of stock that you do not plan to dispose of, but rather intend to hold.

If you hold your shares for a year after you exercise them before selling, you will qualify for capital gains tax rates, which are capped at 20% of the gain (not counting state taxes). If, instead, during that period you held unexercised nonqualified options and then exercised and sold them the same day, that year’s appreciation would be taxed at ordinary income rates, which can range up to 39½% for the federal portion. In essence, the tax on the appreciation is twice the rate if the appreciation occurs prior to exercise than it is if it occurs after you exercise the option.

Even for ISO options, the situation is still a problem. The maximum AMT rate is 28%. Even though the AMT credit normally helps us recover the AMT paid, in this case we will eventually have a regular tax gain being taxed at 20% that will help us recover that difference—so the 8% will be left hanging out there for other differences between the AMT and regular tax to absorb. For those with lots of AMT credit to use up, that differential may prove very difficult to absorb.

Note that it doesn’t always make sense to exercise early. If the stock does not show rapid growth or if you plan to sell the shares immediately after you cash in your options, it may make sense to wait until later to exercise the options. However, the best way to determine what is best is to actually compute your expected results based upon what you actually expect to do.

3. Being too financially dependent on your employer’s performance

Especially if the employer’s stock has been rising for a long time, many employees become blind to the fact that they may depend on that one entity for 90% of their net worth and a similar proportion of their income. Should the market turn and the fortunes of the employer turn down, the employee may find themselves both without a job and with a much reduced "nest egg" to fall back on.

If you are too fixated on the tax implications of selling a portion of your position or are spellbound by the shooting star of the company’s stock price, you may delay diversification until it is too late. From a financial planning perspective, it normally makes sense to accept some tax cost and reduction in return in order to enable diversification out of the single company’s stock.

At the very least, you should be sure that your tax sheltered investments (pensions, IRAs and the like) are invested as much as possible outside of the employer’s securities if you have a large number of shares held outside of such plans. Those entities allow you to rebalance a portion of your portfolio with no current tax impact.

4. Selling or gifting the "wrong" shares after exercise

ISO shares are particularly interesting in this regard. If you have a large amount of minimum tax credit being carried forward, you may find that selling shares with a high AMT basis will cost you little in tax once the one year holding period is up. Similarly, you may find that if you gift away such shares while retaining other, non-ISO shares, you may find it difficult to take advantage of your AMT credit.

Even if AMT isn’t your problem, normally employees who have received a number of options with have many different "layers" of shares, each one with a different tax basis. In that case, using the specific identification method to sell your shares rather than the default first-in, first-out treatment can produce major tax savings. But it is important to note that you must carefully meet the requirements to be allowed to use specific identification.

5. Not taking advantage of stock swaps to exercise shares

A problem many employees have with stock options is the need to come up with the cash to exercise the option if they want to hold the shares. Some end up selling part of the block of shares in order to pay for the exercise, which can trigger extra tax if the block of shares being acquired are ISO shares. The sale of the shares to pay the option price will be a disqualifying disposition.

The IRS issued a ruling back in 1996 (PLR 9629028) that described a way to use already held shares to avoid this result. If the employee has shares previously acquired at least equal to the exercise price, those shares can be used to "pay" the exercise price through what is deemed to be an exchange of those shares for a like number of shares from the option set. No gain is recognized on the transaction, so it’s preferable to selling what may be highly appreciated shares to come up with the money.

One warning is that the approach doesn’t work quite as well if the shares you are exchanging were acquired via the exercise of a prior ISO option and the required holding periods have not been met. In that case, the exchange of the stock would be treated as a disqualifying disposition on the initial stock, triggering ordinary tax equal to the original spread at the first exercise. Still, the appreciation since exercise would escape current taxation.

As always, the best approach to dealing with these matters is to plan before taking any action. Please feel free to call us to schedule an appointment to help plan how you should handle any options your employer may grant you.