John M. Hoffman & Associates CPAs

Frequently Asked Tax Questions

So, lets walk through what happens and why there are complications:

On January 1, 2006 CC announces that the stock is now worth $3, even though there is no readily available market for the stock. 20,000 of your options have vested, meaning you can exercise them at any time. The company says that everything is going great guns and some of those biotech engineered drugs that are ready for testing look very positive.

You ask yourself, what should I do? You have three alternatives:

Do nothing but sit and wait (perhaps not a bad choice).
Exercise and hold some or all of the 20,000 options.
Exercise and try to sell some of all of the 20,000 shares you have options on.

Alternative 3 is not that viable as there is not much of a market for the stock so you might have a hard time finding a buyer. Your company just gave you another 50,000 options vesting over the next five years with a strike price of $4. For these to qualify as ISOs and not have immediate taxation upon grant, the strike price needs to be higher than the current market value which in both cases it was.

The company prospects look real good and you are convinced that there will be a market for your shares in a year or so and you are very interested in the ability to cash in on that future windfall and you want to do it so you only pay capital gains tax on the profit. With that in mind you go to alternative 2. You exercise all 20,000 options on January 1, 2006. Here is where you make an investment because you have to write a check to your company for $40,000 to exercise these options. You trust the valuation that tells you those shares are worth $60,000 and you are confident that the company is going no place but upwards.

What is the tax treatment of this transaction? The $20,000 of paper profit the difference between the $60,000 value of the stock you acquire and the $40,000 you pay for it is considered an alternative minimum tax (AMT) tax preference item. This means that you might pay AMT on this $20,000. You might not pay AMT on this if when you add it all up and you are still not subject to AMT. The bigger the item, the more likely the AMT is. There is no tax consequence for regular (and most state) income tax on this transaction of exercising the ISOs.

So now you have to think about this a bit. You wrote a check to your company for $40,000. Your accountant, Hoffman, is telling you that this is subject to AMT and at 28%, that costs you an additional $5,600. You still like where the company is going – after all - you are one of the brilliant scientist who invented that new drug for CancerCure. Besides, the option was exercised on January 1, 2006 and you won’t have to pay that AMT until April 15, 2007.

Now lets take a look at what can happen from here; now 4 alternatives: