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Area I: Individual Compliance and PlanningTCPIndividual TaxEquity Compensation

CPA · Question 01 · Area I: Individual Compliance and Planning

In Year 1, an executive is granted an Incentive Stock Option (ISO) to purchase 1,000 shares of company stock at an exercise price of $10 per share (the fair market value on the grant date). In Year 3, when the stock is worth $25 per share, the executive exercises the option. In Year 5, the executive sells the stock for $40 per share. Assume the executive meets all holding period requirements for ISO treatment. What are the regular tax and Alternative Minimum Tax (AMT) implications in Year 3 (the year of exercise)?

Answer options:

A.

Regular Tax: $15,000 ordinary income; AMT: No adjustment.

B.

Regular Tax: $0 income; AMT: $15,000 positive adjustment.

C.

Regular Tax: $0 income; AMT: $30,000 positive adjustment.

D.

Regular Tax: $15,000 capital gain; AMT: $15,000 negative adjustment.

How to approach this question

Identify the type of option (ISO vs NSO). Recall that ISO exercise is a non-event for regular tax (unless disqualified) but creates an AMT adjustment equal to the bargain element (FMV - Strike Price).

Full Answer

B.Regular Tax: $0 income; AMT: $15,000 positive adjustment.✓ Correct
Under IRC §421 and §422, the exercise of an ISO does not trigger regular taxable income if holding period requirements are met. However, under IRC §56(b)(3), the difference between the fair market value at exercise ($25) and the exercise price ($10) is an adjustment for AMT purposes. 1,000 shares * ($25 - $10) = $15,000 positive AMT adjustment.

Common mistakes

Confusing ISOs with NSOs; forgetting the AMT implication of ISOs; calculating the spread using the grant date value instead of exercise date value.
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