What happens with AMT if you exercise stock options in a private company and sell in the same year, but the sales price is less than the 409 value of the company?

Question: (org. on Quora)

What happens with AMT if you exercise stock options in a private company and sell in the same year, but the sales price is less than the 409 value of the company?

So let’s say your ISO option strike price is $10 and the latest 409 valuation puts the stock at $40 a share, but you sell for $20 a share in the same year you exercised. Do you have to pay AMT on the difference between $10 and $40 or is it just considered a normal stock sale that you paid $10 and sold for $20 and AMT is irrelevant? Will there be any issues with the IRS since the price paid for the shares is less than the recent 409 value?

Answer (by Dan Walter)

This is a great question and an important fact for Incentive Stock Option (ISO) holders to be aware of.

When you exercise an ISO the spread is an Alternative Minimum Tax Income preference item. If you simply exercise and hold you will be required to perform an AMT tax calculation (there are lot’s of posts and discussions about tis, so I won’t go into the details.

If you sell, gift or “otherwise hypothecate” your exercised ISOs within 2 years of the grant date and 1 year of the exercise date you have disqualified them from preferential tax treatment (a “disqualifying disposition”).

A disqualifying disposition that occurs in THE SAME CALENDAR YEAR as the exercise that caused the AMTI preference items, negates the AMTI preference item and no AMT calculation is required when preparing your taxes in the following calendar year.  BUT, if you forget and hold the shares until even January 1 of the calendar year following the exercise, you will be forced to do the calculation and, perhaps, pay the associated taxes.

The trick is this.
IF you exercise and ISO and choose to hold any or all of the resulting shares in order to potential receive the tax benefit of avoiding ordinary income taxes in favor of capital gain taxes…
THEN you should have a tax professional or a qualified investment advisor of some sort help you evaluate the resulting shares in early December of the same year as the exercise.
IF the AMT risk seems high, it may make sense to get rid of the shares, take the ordinary income hit and pay the associated taxes.
If the AMT risk seems low, it probably makes sense to hold the shares and take advantage of the great saving that capital gains rates offer you.

NOTE: I am not a qualified tax advisor or attorney or financial advisor. While I do have extensive knowledge of these issues nothing here should be considered advice or guidance.  You must speak to your own advisors about your specific facts and circumstances to get advice about this issue.