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Both Kinds of Stock Options Can Lead to Tax-Time Trouble

April 13, 2001|LIZ PULLIAM WESTON

Workers can get stuck in a stock option tax trap in one of two ways, depending on which type of options they used to buy company shares.

With both kinds of options--incentive stock options and the more common nonqualified options--the tax is based on the difference between the low price the employee pays for the stock and its actual value on the day the stock is purchased.

With nonqualified options, the paper profit is reported to the IRS and included in workers' W-2 forms at the end of the year. Workers who purchased the shares and did not immediately sell them risk watching the stock price decline but still having to pay taxes based on their phantom profit.

With incentive stock options, the tax is more insidious. The paper profit is not counted for normal income tax purposes, and there's even a tax incentive to hang on to the shares: The growth can qualify for favorable capital gains rates if the shares are held for more than a year.

That's why many employees who use incentive options choose to hang on to their shares.

The problem is that using incentive options to buy company shares triggers the alternative minimum tax, or AMT, a parallel tax system devised by Congress to make sure the rich don't completely avoid taxes.

Not only are the paper profits counted as taxable income, but a variety of deductions--including state taxes and some kinds of mortgage interest--are disallowed under AMT rules.

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