Judicious exercise of stock options is behind many a young fortune

''They've made more millionaires than Ray Kroc'' of McDonald's fame, says Thomas J. McFarland of the New England Financial Planning Group in Burlington, Mass.

''They'' are incentive stock options (ISOs). If you know someone who has made a bundle working for a young company, he or she has likely done it through judicious exercise of ISOs and their brethren, nonqualified stock options (NSOs).

Stock options are closely identified with growing young companies in California's Silicon Valley and other technology hotbeds. But, notes Marilyn J. Pitchford, a tax partner in the Boston office of Arthur Young & Co., ''A lot of Fortune 500 companies offer incentive stock options.''

Indeed, of the nation's 25 highest-paid executives in 1983, none would have made the list on the basis of salary and bonus alone; stock options had to be figured in.

A stock option is a kind of compensation a company offers employees: the right to buy a certain number of shares of company stock at a specified price anytime over a certain period of years. The idea is that the stock price will rise and the employee will be able to buy shares at bargain-basement prices.

For the employee, this is ''a highly desirable benefit,'' as Arthur Young & Co. has called it, with the understatement befitting an accounting firm.

From the employer's point of view, stock options are a good way to give employees a stake in the company - and not just the eager-beaver engineers and other top employees. ''We have guys making $30,000 to $35,000 a year maintaining machines for some of these companies and they are coming to us for helping in managing their stock options,'' says Mr. McFarland.

Getting the most of your stock options is rather tricky. The object is to exercise your options so as to get the best return - but not so good that alternative minimum tax liability is triggered.

Don't let the word ''minimum'' fool you: You don't pay the alternative minimum tax unless it's a greater amount than you would owe if your taxes were calculated in the regular manner.

The alternative minimum tax is calculated at a lower rate but on a broader base than regular income tax is. The AMT is designed to keep tax shelters from working too well; taxpayers become liable for AMT when their tax-preference income, such as capital gains, looms too large in relation to ordinary income, such as salary.

One way to forestall liability for the AMT is to take advantage of the differences between ISOs and NSOs. The former are more severely restricted, cost more for the employer to offer, and have greater tax benefits than the latter.

In an NSO plan, the ''bargain element'' is taxed as ordinary income, like a Christmas bonus, for example: If you exercise an option to buy at $10 a hundred shares of stock currently selling at $20 a share, the $1,000 bargain element is taxed at the employee's usual marginal tax rate - 50 percent, say.

Under an ISO plan, the bargain element is not taxed as ordinary income unless the employee sells the stock less than two years after the option is granted.

But ordinary income may be just what you need if you're in danger of tax liability for the AMT. Financial planners advise that one way to forestall this tax is to generate more ordinary income. If you have both ISOs and NSOs, you might want to exericise some of them.

If you have only an ISO, selling the stock before the two-year limit is up would ''force it into a nonqualified stock option,'' Ms. Pitchford says, generating ordinary income.

There is another bind that holders of ISOs sometimes get into. ISOs must be exercised in the order in which they are granted. If you have options to buy stock at $10 a share and $5 a share, you will want to exercise the latter option first if the stock is trading at $7.50. ''Hey, $10 a share is no great bargain, '' you may say. But if the $10 option was issued first, to exercise the $5 option would knock out your tax advantages, giving you ordinary income. (That may, however, be exactly what you want.)

What about selling stock? Diversification is the investor's watchword. Isn't it a good idea to sell some of the employer's stock and invest in something else?

''That's a difficult question,'' says Ms. Pitchford. For one thing, she notes , anyone in a high position at a large public company needs to consider whether he or she falls under Securities and Exchange Commission regulations on insider tradiing. ''And then it can be a little sensitive - you don't want to seem to be lacking in loyalty to the company. There are a lot of nonfinancial considerations in all this.''

Which is not to say there aren't plenty of financial considerations, too. John Hart, corporate tax director at the Bank of New England Corporation, points out that there is a basic problem with all stock options: ''Somebody's got to come up with the money to buy the stock.'' For a young executive - or nonexecutive - this could be tricky.

What he suggests instead is stock appreciation rights - SARs. These are in effect the right to claim a cash bonus equal to the appreciation of company stock upward from a specified value.

Suppose an SAR is granted with the stock price is $10 a share. The stock rises to $30, and the employee decides to exercise the SAR. He receives $20 per share in cash. He never owns the stock, but he never has to scrape together the cash to buy stock, either, not even at a bargain price. (On the other hand, he could take the SAR money and buy stock if he wanted to impress the boss with his corporate loyalty - or if he felt the stock would keep rising.)

Both stock options and SARs serve as ''golden handcuffs'' for employees, Mr. Hart notes - giving them an incentive to stay with the company and work hard to push its stock up.

On ISOs, ''I've taken the extreme position that they don't make sense,'' from the company's point of view, he says. The tax advantages for the employee are disadvantages for the employer. He suggests that employers grant deductible NSOs instead, and just give the employee an additional cash bonus to make up for what is lost to taxes on ordinary income.

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