The main difference between an incentive stock option (ISO) and a non-qualified stock option (NSO) is the tax consequence to the employee and the deductibility to the employer. With an ISO, the employee pays no taxes until the stock is sold (assuming that the employee is not subject to alternative minimum tax). If the employee holds the stock at least two years from the grant date and one year from the exercise date, the gain on the sale (i.e. the difference between the price paid for the stock (exercise price) and the proceeds received from the sale) would be characterized as a capital gain and taxed at the lower capital gain rate. The employer in this case would receive no tax deduction on the stock option transaction.

With an NSO, the employee is taxed at the time the employee exercises the option on the difference between the amount paid for the stock (exercise price) and the fair market value of the stock option at the exercise date. This gain would be characterized as ordinary and would be taxed at the higher ordinary income tax rates. The employer would receive a tax deduction equal to the amount of income the employee must recognize.

The decision on which type of stock option to establish, ISO versus NSO, should be based on a number of factors, including:

liquidity probability during the option term;
prospects for taxable income at the corporate level during the option term; and,
the estimated stock-value growth over the option term.
For companies that do not expect a liquidity event prior to the time in which the stock options will be exercised, it may be more advantageous to issue ISOs. This is because the tax consequences to the employee can be so significant at the exercise date that they may preclude him/her from exercising the option, especially if the value of the stock increases significantly during the option term. If the company does not expect to have taxable income during the stock option period, the issuance of ISOs probably makes better economic sense than NSOs. This is because the company tax deduction available with NSOs is worth less when the company is not profitable (although deductions may be carried forward to profitable years according to tax laws.)

Looking at a stock option transaction strictly from an economic sense, it is clear, in most situations, that the use of NSOs will reduce the overall tax liability of the employee and employer combined. It is also clear that employees favor ISOs over NSOs because ISOs allow them to convert ordinary income to capital income and defer the gain on the option transaction until the stock is sold. A company must weigh the difference between the economic benefit an NSO allows versus the increased employee incentive that an ISO creates.

ISOs are often the standard practice for pre-IPO companies because there are no tax consequences for the company. The significance of this is that Wall Street is used to seeing ISOs and calculating the consequence of these options on dilution. In marketing the IPO, VC companies do not necessarily want to complicate the process by having to explain the tax impact of NSOs to potential investors.

Public companies usually issue NSOs due to the economic advantage they give the corporation. Even if a public company issues ISOs, research shows that most employees sell their shares immediately after the option is exercised, thereby converting the ISO to an NSO for tax purposes.

There are various limitations on ISOs. For example:

the option price cannot be less than 100% of fair market value at exercise;
the option term cannot be more than 10 years;
the value of the options that first become exercisable by any one individual in one year is limited to $100,000 measured at the date of grant; and,
ISOs can only be issued to employees.
If the options granted do not include these provisions, or are granted to non-employees, the options will be characterized as NSOs.

--Originally published at http://www.fed.org.onlinemag/june98/tips.htm. Reprinted with permission of the Foundation for Enterprise Development.
Title - "When to Use an Incentive Stock Option versus a Non-Qualified Stock Option"
Author - Ron Bernstein of the Foundation for Enterprise Development staff

The alternative minimum tax (or AMT) is an extra tax some people have to pay on top of the regular income tax. The original idea behind this tax was to prevent people with very high incomes from using special tax benefits to pay little or no tax. But for various reasons the AMT reaches more people each year, including some people who don't have very high income and some people who don't have lots of special tax benefits. Congress is studying ways to correct this problem, but until it does, almost anyone is a potential target for this tax.

The name comes from the way the tax works. The AMT provides an alternative set of rules for calculating your income tax. In theory these rules determine minimum amount of tax that someone with your income should be required to pay. If you're already paying at least that much because of the "regular" income tax, you don't have to pay AMT. But if your regular tax falls below this minimum, you have to make up the difference by paying alternative minimum tax.

Unfortunately, there's no good answer to this common question — which is one of the big problems with the AMT. You can have AMT liability because of one big item on your tax return, or because of a combination of many small items. Some things that can contribute to AMT liability are very mundane items that appear on many tax returns, such as a deduction for state income tax or interest on a second mortgage, or even your personal and dependency exemptions. See Top 10 Things that Cause AMT Liability.

If you use computer software to prepare your tax return, the program may be able to do the AMT calculation. If you're preparing a return by hand, the only way to know for sure is to fill out Form 6251 — a laborious process.

There are two essential pieces to the AMT. First, you need to understand how your AMT liability is calculated for a year when you pay AMT. And second, you need to know how the AMT credit can reduce your taxes in years after the year you paid alternative minimum tax.

AMT Liability

The best way to understand alternative minimum tax liability is to see how it's calculated. Here's the big picture.

Compute an Alternate Tax
First, you figure the amount of tax you would owe under a different set of rules. What's different about these rules? Broadly speaking, three things:

• Various tax benefits that are available under the regular tax are reduced or eliminated.
• You get a special deduction called the AMT exemption, which is designed to prevent the AMT from applying to taxpayers with modest income. This deduction phases out when your income reaches higher levels, a fact that causes significant problems under the alternative minimum tax.
• You calculate the tax using AMT rates, which start at 26% and move to 28% at higher income levels. By comparison, the regular tax rates start at 15% and then move through a series of steps to a high of 39.6%.

The result of this calculation is the amount of income tax you would owe under this "alternative" system of tax.

Compare with the Regular Tax
Then you compare this tax with your regular tax. If the regular tax is higher, you don't owe any AMT. But if the regular tax is lower, the difference between the two taxes is the amount of AMT you have to pay.

Example 1: Your regular income tax is $47,000. When you calculate your tax using the AMT rules, you come up with $39,000. That's lower than the regular tax, so you don't pay any AMT.

Example 2: Your regular income tax is $47,000. When you calculate your tax using the AMT rules, you come up with $58,000. You have to pay $11,000 of AMT on top of the $47,000 of regular income tax.

If you're paying attention, you've probably noticed that the total amount of tax you pay in Example 2 is equal to the tax calculated under the AMT: $58,000. But it's important to note that you actually pay $47,000 of regular tax plus $11,000 of AMT, as we'll see below.

Reporting: To calculate and report your AMT liability you need to fill out Form 6251, Alternative Minimum Tax — Individuals.

Estimated tax: You're required to take your AMT liability into account in determining how much estimated tax you pay. For information about estimated tax payments, see Guide to Estimated Tax.

AMT Credit

Here's good news: a portion of your AMT liability — perhaps all — may reduce the tax you pay on future tax returns. Working with this AMT credit is a two-step process. First you find out how much credit is available, then you find out how much of the credit you can use.

Find the Available Credit
The first part of your task is to find out how much of the AMT liability from a prior year is eligible for the credit. This involves calculating the alternative minimum tax under a different set of rules — sort of an alternative AMT. What you're doing here is finding out how much of your alternative minimum tax liability came from timing items: items that allow you to delay reporting income, as opposed to items that actually reduce the amount of income or tax you report. If you're lucky, your entire AMT will be available as a credit in future years. But some people find that only a small portion, or none at all, is available for use as a credit.

Determine How Much AMT Credit You Can Use
If you have some AMT credit available from a prior year, you have to determine how much of the credit you can use in the current year. You can only use the AMT credit in a year when you're not paying alternative minimum tax.
    The amount of credit you can use is based on the difference between your regular tax and the tax calculated under the AMT rules.

Example: Suppose you have $8,000 of AMT credit available from 1997. In 1998 your regular tax is $37,000. Your tax calculated under the AMT rules is $32,000. You don't have to pay AMT because your regular tax is higher than the tax calculated under the AMT rules. Better still, you're allowed to claim $5,000 of AMT credit, reducing your regular tax to $32,000.

In this example, you would still have $3,000 of AMT credit you haven't used. That amount will be available in 1999. In tax lingo, it's carried forward.
    Of course, you can't claim more than the amount of the available credit. In the example, if the AMT credit available from 1997 was $2,700, then you would use the full amount of the credit in 1998. You would reduce your regular tax to $34,300 — not all the way to $32,000.

Reporting: To calculate and report your AMT credit you need to fill out Form 8801, Credit for Prior Year Minimum Tax — Individuals, Estates, and Trusts.