Page 190 - Essentials of Payroll: Management and Accounting

Benefits
The alternative minimum tax (AMT) must also be considered when
dealing with an ISO plan. In essence, the AMT requires that an employee
pay tax on the difference between the exercise price and the stock price
at the time an option is exercised,even if the stock is not sold at that time.

This can result in a severe cash shortfall for the employee, who may only
be able to pay the related taxes by selling the stock. This is a particular
problem if the value of the shares subsequently drops, since there is now
no source of high-priced stock that can be converted into cash in order
to pay the required taxes. This problem arises frequently after a company
has just gone public, and employees are restricted from selling their shares
for some time after the IPO date, thus run the risk of losing stock value

during that interval. Establishing the amount of the gain reportable under
AMT rules is especially difficult if a company’s stock is not publicly held,
since there is no clear consensus on the value of the stock.In this case,the
IRS will use the value of the per-share price at which the last round of
funding was concluded.When the stock is eventually sold, an AMT credit
can be charged against the reported gain,but there can be a significant cash
shortfall in the meantime. In order to avoid this situation, an employee
could choose to exercise options at the point when the estimated value of
company shares is quite low, thereby reducing the AMT payment; how-

ever, the employee must now find the cash to pay for the stock that he or
she has just purchased, and runs the risk that the shares will not increase
in value and may become worthless.
An ISO plan is only valid if it follows these rules:
• Incentive stock options can only be issued to employees. A person
must have been working for the employer at all times during
the period that begins on the date of grant and ends on the
day three months before the date when the option is exercised.
• The option term cannot exceed 10 years from the date of grant.
The option term is only five years in the case of an option
granted to an employee who, at the time the option is granted,

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