Got stock options? Sorry to hear that.

Just a few months ago, having stock options -- especially from an IPO -- meant you had found the

Holy Grail. But these days, holding stock option certificates in many cases is the equivalent of wearing

Hester Prynne's

Scarlet Letter.

That's because too many companies are way off their

IPO highs and the tax rules are so confusing that exercising these things can scar you for life.

So before you exercise a thing, it's imperative that you drop some numbers into tax preparation software and get a feel for what it's going to do to your tax bill.

There are two types of options available --

nonqualified stock options, a.k.a. nonquals, and

incentive stock options, or ISOs. The big difference between them is in the way they are taxed.

When you exercise nonquals, you pay ordinary income tax on the difference between the exercise price -- or

strike price -- and the stock's market price on the date of exercise, or when you actually buy the stock. After that, all further appreciation is taxed at the capital gains rates.

With ISOs, all appreciation over the strike price is taxed at the long-term capital gains rates of 20% when you sell, assuming you hold the stock for at least two years after the options are issued or one year after exercise, whichever is longer. But that's assuming you're not a casualty of the alternative minimum tax, or AMT. Read this previous

column for more details on the AMT system.

If your ISO exercise falls victim to AMT, you'll owe AMT (up to 28%) on the difference between the strike price and the stock's market price at the time of exercise. AMT is ugly and complicated, so avoiding it is usually a good bet.

Let's walk through some scenarios now that -- hopefully -- will help you lessen your tax pain in April.

You exercised ISOs earlier in the year and the stock has tanked since.

As we discussed on

Thursday, sometimes the best thing to do when the stock is down and you don't believe it's ever coming back, is just to "disqualify" the position.

As a quick recap, disqualifying your position is accountant-speak for selling the stock before Dec. 31. Remember, you're supposed to hold your ISO shares for at least two years after your options were issued or one year after you exercised to guarantee yourself the 20% long-term capital gains rate on any appreciation. But if you wait that long, you may not have any appreciation left the way your stock is sinking.

By "disqualifying," you no longer qualify for the long-term capital gains rates. Instead, you'll owe ordinary income tax on the difference between your strike price and the fair market value of the stock on the day of the sale. The good news is that you avoid paying AMT.

Being generous won't save you from a tax hit either. If you give away ISO stock before you've held it for at least two years from the date of grant and at least one year from the day you exercised, you'll still pay ordinary income tax on the difference between your strike price and the stock's fair market value on the day of exercise, says Martin Nissenbaum, director of income tax planning at

Ernst & Young

. So if your strike price is $5 and you exercise at $20, you'll be taxed on $15 of ordinary income, even though the shares are trading at, say, $10.

You exercised ISOs and the stock has gone up.

Lucky you.

If you exercised earlier this year and your stock is doing well, you have a decision to make. You may owe AMT on the spread between your strike price and the stock's price on the day you exercised. But, assuming the stock keeps rising, you'll get a credit back for that tax paid. So that's a gamble you may want to take.

"But if you have lost faith in the company or think the stock is on a fluke run, then consider disqualifying before things get ugly," suggests Bill Fleming, director of personal financial services for


in Hartford, Conn.

Now may be a time to think charitably. If you've held your shares for at least two years from the date of grant and at least one year from the day you exercised, you can give the shares away, suggests Nissenbaum. Then the appreciation is out of your estate. The good news is that if you have paid AMT on your initial exercise, you can still use that credit for something else, says Nissenbaum. Even better, when you donate appreciated stock that you have held that long, you'll get a charitable deduction for the full market value of the donated shares.

You might also consider giving the shares to someone in the 15% tax bracket and having that person sell them. Remember, capital gains rates are dropping in 2001 from 10% to 8% for taxpayers in that bracket. So as long as the person is over 14 (kids under 14 are taxed at their parents' tax rate), he or she can sell the stock immediately and will owe only an 8% capital gains tax on the appreciation.

The capital gains rates also are dropping for taxpayers in the higher brackets, from 20% to 18% on assets purchased after Jan 1, 2001, and held for five years. This doesn't help you if you have unexercised stock options. The date you received the options is when the ownership clock begins ticking. So if you received options before 2001, but exercised in 2001, the stock you receive on exercise will not qualify for the 18% rate. The 18% rate applies only to gains on stock purchased after 2000, or on stock received from the exercise of options granted after 2000.

Check out this previous

column for more details on the rates.

What do I do with nonquals?

While you don't have to sweat the AMT with the exercise of a nonquals, you do have to worry about paying ordinary income tax on the spread between your strike price and the stock's current trading price. So the higher the stock price, the bigger your tax bill.

If you haven't exercised yet and your options are not pre-IPO, then you may be better off waiting a while to avoid a big tax hit, suggests Fleming.

But if their value has slipped, you may consider paying ordinary income now so you can pay the capital gains rates on any future appreciation, says Nissenbaum.

And here's a tip: If you do exercise nonquals before year-end and you know you've underpaid your tax bill for the year, ask to have the maximum amount of tax withheld.

The Internal Revenue Service

assumes withholding tax is paid in

equal installments throughout the year, so you will not owe penalties for withholding a lump sum. So it's a great way to beef up your withholding.

Before you make a decision, crunch some numbers to determine what the best scenario is for you. Granted, your investment decisions should not be based on taxes, but you don't need Uncle Sam to profit at your expense.

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TSC Investor Forum aims to provide general investment information. It cannot and does not attempt to provide individual advice. All readers are urged to consult with a professional as needed about their individual circumstances.