ExpertMedium1 markMultiple Choice
CPA · Question 01 · Area I: Individual Compliance and Planning
In Year 1, an executive is granted 1,000 Incentive Stock Options (ISOs) with an exercise price of $10 per share when the market price is $10. In Year 3, the executive exercises all options when the market price is $50 per share. In Year 5, the executive sells the stock for $70 per share. Assume the executive meets all holding period requirements. What are the tax consequences in Year 3?
In Year 1, an executive is granted 1,000 Incentive Stock Options (ISOs) with an exercise price of $10 per share when the market price is $10. In Year 3, the executive exercises all options when the market price is $50 per share. In Year 5, the executive sells the stock for $70 per share. Assume the executive meets all holding period requirements. What are the tax consequences in Year 3?
Answer options:
A.
Ordinary income of $40,000 for regular tax purposes.
B.
No income for regular tax purposes, but an AMT adjustment of $40,000.
C.
Capital gain of $40,000 for regular tax purposes.
D.
No income for regular tax purposes and no AMT adjustment.
How to approach this question
Distinguish between ISOs and NSOs. For ISOs, exercise is not a taxable event for regular tax but creates an AMT adjustment equal to the spread between FMV and exercise price.
Full Answer
B.No income for regular tax purposes, but an AMT adjustment of $40,000.✓ Correct
B
Under IRC §421 and §56(b)(3), the exercise of an ISO does not trigger regular income tax if holding periods are met. However, the difference between the fair market value at exercise ($50) and the exercise price ($10) is an adjustment for Alternative Minimum Tax (AMT) purposes in the year of exercise. $40 spread × 1,000 shares = $40,000 AMT adjustment.
Common mistakes
Confusing ISOs with NSOs (which trigger ordinary income on exercise) or forgetting the AMT implication of ISOs.
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