In 2000 I was working with several dot-com companies and incentive stock options (ISO's) were a hot topic. ISO's were used to lure in new recruits, poach executives from other companies and make up for the mediocre compensation most tech start-ups offered. With the internet bust ISO's fell out of favor, or at least out of the news. That is, unless you follow tax law. Over the last several years there have been a steady stream of tax court cases and news reports about taxpayers racking up huge tax liabilities as the result of option exercises. These cases play well in the press because the tax liability can come due when the taxpayer has no cash to pay it and only a pile of worthless stock certificates to show for their efforts.

Recently ISO's seem to be making a come back. Well established companies have started offering ISO's to offer as additional compensation in today's tight labor market. The resurgence of tech companies and pure internet plays is also driving the ISO rebound. Here's what you need to know to understand how these little gems cause so much trouble for taxpayers.

A stock option is the ability to buy a stock at a predetermined price (the strike price). If the market value of the stock is above the strike price then the option has a value equal to the difference. If the fair market value is below the strike price the option is said to be 'under water' and is worthless.

Normally when you exercise an option the difference between the strike price and the option price is deemed compensation and subject to ordinary income taxation (as well as payroll tax in some cases). If the company sets up the plan in a certain way it becomes a qualified incentive stock option plan (ISO) and the tax treatment is deferred until the underlying stock is sold. Not only is the tax deferred, but it gets capital gains treatment if the buyer holds the stock for one year after the option is exercised.

But here's the rub. The alternative minimum tax (AMT) does not recognize ISO's. As far as the AMT is concerned you have realized income equal to the difference between the strike price and the stock's fair market value on the date of exercise. This can create a huge AMT tax liability. If the story ended there it might not be such a problem. After all, you have stock worth millions so you ought to pay the tax on it, right? And you should be able to eventually get a credit for the AMT tax you pay.

Here's the problem. Since you exercised ISO's you can't sell them for a year. If the stock tanks during that year you are left with worthless securities, and a huge tax bill. Further, limitations on the AMT credit mean it can take a lifetime to recoup the AMT paid in the year of exercise. This all adds up to a tax situation that seems ill conceived at best and horribly inequitable at worst. The problem is that the AMT was enacted before ISO's became common place and it has not evolved to address them. Different groups continue to lobby congress but there is still no substantive AMT reform forthcoming.

So what should you do if you end up with a load of ISO's? In some ways you are rolling the dice. If you exercise the options and wait the year to get favorable capital gains treatment you run the risk of generating an AMT bill you will have no way to repay if the stock collapses. The alternative is to ignore the ISO's favorable tax treatment, sell the stock, pay ordinary income tax and use the remaining proceeds as you wish.

Unfortunately, the options are not always clear cut to the employees who receive ISO's. Many believe the stock is restricted or are misinformed by unknowing managers who hold a different class of shares or who participate in a non-qualified stock option plan. If you have access to an ISO make sure you get a complete copy of the plan document and your option vesting schedule. Then review both with your CPA or tax attorney to determine the best course of action.

Joey Brannon is the founder of Axiom Professional Group, a tax, consulting and accounting firm in Bradenton, Florida. Mr. Brannon is both a CPA and an EA. You can find out more about Axiom by visiting www.axiomcpa.com.