What are some disadvantages of the way the tax code treats incentive stock options?
There are three primary problems with the way the tax code treats incentive stock options. First, the tax code gives an employee a strong incentive to exercise the options early on, to achieve the tax benefit relating to the special option treatment. This means the tax code encourages young employees to write a check to their employer at a time when their entire financial life is likely to be dependent on that employer. This is the exact opposite of diversification, a key goal of personal financial management. The second issue is that the alternative minimum tax (AMT) is imposed at the time of exercise. This requires a potentially large cash outlay, at a time when the employee is unlikely to have sufficient liquidity to meet the burden. So not only does the employee have to pay his or her employer to cover the exercise premium, he or she has to send funds to the Internal Revenue Service as well. Finally, the requirement that an employee terminating employment must exercise within three months of termination date to preserve the tax advantage of the options encourages exercise at a time when the employee may not have sufficient funds, and may be looking at financial uncertainty if he or she does not yet have a new job lined up. The advantages of incentive stock options are significant, but they encourage the wrong behavior.