A Recap
In Part One, I explained that there are two types of statutory stock option plans, incentive stock options ("ISOs") and options granted under a company's stock purchase plan. Generally, these options are not taxed until the employee disposes of the option and gains are treated as capital gains. If the option is held for 12 months or more, the Optionee will have long-term capital gains, taxed at a maximum of 20 percent federal.

The most popular stock option plan involves ISOs. These are granted by a corporation to an individual in connection with employment, provided the IRS code provisions governing ISOs are met. The employee has no tax consequences from receiving or exercising an ISO and the employer receives no deduction.

Alternative Minimum Tax
The value of an ISO is included as income under the alternative minimum tax (AMT) rules. The income amount is usually the value of the option at the time there are no restrictions on its exercise over the price paid for the ISO.

In Joe's situation in Part One, the value of Start-Up's stock over the option price, $4,500, is a positive adjustment under the AMT rules. Generally, a spread this small will not trigger the AMT. If, however, Start-Up's stock is increasing in value, Joe should exercise his stock options as soon as possible.

Assume that Joe received an ISO and at the end of the second year, Start-Up's stock was worth $1 a share. If Joe exercised his option to buy 50,000 shares, he could fall within the AMT ($49,500 spread). Instead, Joe elects to exercise his option as to 25,000 shares at the end of the second year and another 25,000 at the beginning of the next year. This will stretch the AMT adjustment over two years and may eliminate an AMT tax on the exercise. This strategy could backfire if the stock value continues rising, or if there is an IPO ("initial public offering") or merger with a large company.

Use IRS Form 6351 to determine your AMT exposure and what steps can be taken to lessen the AMT impact. Selling investments at a loss to offset investment gains will reduce your AMT. Also, remember that tax-free "private activity bonds" reduce your regular taxes, but do not lessen the AMT. In short, if you receive ISOs, it is important to understand the AMT consequences when you exercise them.

A Short-Hand Method To Avoid the AMT
You will need Form 1040 (regular tax) and Form 6351 (alternative minimum tax) to perform this calculation. Determine your regular tax (assume $20,000) and your alternative minimum tax (assume $15,000). Subtract the difference ($5,000) then divide the $5,000 by the AMT tax rate of 26 percent ($19,230). Divide the $19,320 by the Spread (assume $10) = 1,932 shares may be exercised without triggering the AMT.

Regular Tax (Form 1040)	$20,000
AMT (Form 6351)	$15,000
Difference	$5,000
Divide by AMT Rate (26%)	$19,320
Divide by Spread Per Share	$10
Maximum Number of Shares That May Be Exercised Without AMT	1,932

Creative Tax Planning With Stock Options
Although ISOs have certain advantages, they pose an AMT risk. There are also strict rules regarding the holding period for the option and the stock acquired through the exercise of the option. For small start-ups, the non-statutory stock option may be more advantageous, especially if the spread is small and the company hopes for a huge increase in stock value in the future through an IPO or acquisition by a larger, publicly-traded company.

Estate Planning Opportunities With Non-Statutory Options
Certain non-statutory options may be used effectively for estate planning. The IRS has ruled that the transfer by the owner of non-statutory stock options, without a readily ascertainable value, to an irrevocable trust for the benefit of his family is a completed gift.

When the options become subject to tax, the owner will be taxed on the spread. This means that the trust will receive the full value without tax. There is a gift tax based on the value of the property transferred, but if the spread is nonexistent or very small, little, if any, gift tax will be paid. A properly drafted trust will maximize the owner's annual gift tax exclusion, currently $10,000 ($20,000 for a husband and wife) per donee per year.

In the above example, if Joe transferred his Start-Up stock options (when the options had no readily ascertainable value) to an irrevocable trust, he would pay the tax on them when the value of the options became ascertainable (assume $4,500), but the trust would own the stock. If the trust exercised the options to obtain maximum value, then $3 million would reside in the trust.

Upon Joe's death, the entire value of the trust would escape estate tax. Also, the trust provides asset protection against Joe's future creditors since the trust's assets do not belong to him. This could provide Joe security should he decide to start a new business venture.

For this technique to work, the company's non-statutory stock options would have to be transferable to a trust. Stock option plans often do not permit such transfers. By definition, ISOs must be owned by the employee; therefore, they cannot be transferred to a trust.

Conclusion
Stock options are powerful incentives with potentially huge payoffs, provided the employee understands how his or her particular company plan works. For start-ups with relatively small spreads and a readily ascertainable value, the non-statutory stock option, with immediate vesting, is probably the best alternative. Be sure to exercise the option once the spread becomes taxable to you. To obtain the maximum capital gain, you must hold the stock for at least 12 months.

ISOs have their advantages as well. There is no ordinary income tax element upon receipt or exercise, and the subsequent stock sale results in capital gains treatment. Of course, there are several requirements with ISOs, chiefly that the option must be held for at least two years and the stock must be held for at least one year after the option is exercised. With the ISO, although there is not a tax upon exercise, the spread at the time of exercise is considered a positive adjustment under the AMT, so carefully calculate the AMT consequences.