The Advisors' Blog

– Liz Dunshee

To help optionees limit their alternative minimum tax, some companies grant options that can be exercised early. This Dorsey & Whitney memo explores the mechanics & tax risks pertaining to optionees for early-exercise ISOs vs. non-qualified stock options. Here’s a teaser:

In 2004, final ISO regulations clarified that Section 83(b) elections filed on restricted stock acquired via early exercise ISOs are only effective for AMT purposes and not for ordinary compensation tax purposes.

In the best case where both ISO holding periods are met (the shares acquired via ISO are held at least two years from the date of grant and at least one year from the date of exercise, prior to sale), the entire spread between the sale price and the exercise price paid will be taxed as long-term capital gain. However, if either holding period is not met, a “disqualifying disposition” occurs.

As compared to an ISO, the exercise of a non-qualified stock option is not a preference item for AMT purposes. If an optionee early exercises a NSO, an 83(b) election will be respected for compensation purposes and the optionee will only recognize compensation income equal to the fair market value of the shares on the date of exercise less the option’s exercise price.