Tax Guide to Incentive Stock Options (ISOs)

Incentive stock options (ISO) are a special benefit offered to employees. Under an incentive stock option plan, companies give their employees the right, if they so choose, to purchase stock in the employer’s business at a predetermined, set price.

Incentive stock options can trigger tax impacts at two points in time: when the stock is purchased, and again when the stock is sold.

Thus to get the lowest tax rate possible, we need to manage both the exercise of the incentive stock options and the sale of the stock.

Quick Overview of Option Terminology

First, a quick overview of terminology related to incentive stock options:

  • Strike Price or Exercise Price – Both mean the same thing and refer to the set price at which an employee can purchase stock. This price is set at the time the options are granted and does not change over time.
  • Fair Market Value (FMV) – reflects the value of a company’s stock at a particular point in time. For publicly-traded companies, the market value is determined by the average of the highest and lowest selling prices of the stock on a particular day. For privately-held businesses, the value of the stock is determined by a formal appraisal.
  • Spread or Bargain Element – The fair market value of the stock on the day an ISO is exercised minus the strike price of the ISO.

An incentive stock option goes through five phases during its lifecycle:

  • Grant – when the employer grants the option award package to an employee.
  • Vest – when an incentive stock option becomes available to exercise.
  • Exercise – when the employee uses the option to purchase stock.
  • Hold – the period of time during which the employee owns the stock.
  • Sale or disposition – when the employee sells or otherwise disposes of the stock.

Tax Treatment when Exercising Incentive Stock Options

When employees exercise their incentive stock options, they pay the strike price and acquire the shares of stock. An ISO gives the employee the right to purchase shares of stock in the employer’s business at a predetermined price, called the strike price. On the day that an employee exercises their ISO, the stock’s price might be trading at a higher price on the open markets as compared to the strike price. This difference between the fair market value of the stock on the exercise date and the strike price of the option is added to a person’s income when calculating the Alternative Minimum Tax (AMT).

The smaller the spread, the smaller the amount of income included for AMT purposes. In the situation where the fair market value of the stock equals the exercise price (as it does when the option is initially granted), the employee would have zero income to include for AMT purposes.

Tax Treatment when Selling Incentive Stock Options

When stock is sold, individuals record as income the difference between the selling price and the cost basis of the stock. The same is true when a person sells stock that was originally acquired through an incentive stock option. However, there is an extra step we need to take.

For incentive stock options, the increase in value in the stock needs to be split into two components: compensation income and capital gains income, each with different tax rates applied. How we split up this income depends on whether the person owned the stock long enough for the sale to be classified as a qualifying disposition.

A sale is classified as a qualifying disposition if the person:

  • Holds the stock more than 2 years from the grant date and
  • Holds the stock more than 1 year after the exercise date and
  • Was continuously employed by the employer granting the ISO from the grant date up to 3 months prior to the exercise date
    • (or 1 year before the exercise date if the worker is disabled).

A sale not meeting these criteria is classified as a non-qualifying disposition also known as a  disqualifying disposition.

In a qualifying disposition, the entire difference between the selling price and the cost basis of the stock is classified as long-term capital gains. The cost basis of the stock is the amount paid for the stock, which would be the exercise price paid plus any brokerage fees or commissions. For alternative minimum tax purposes, the cost basis of the stock is adjusted for the spread between the fair market value of the option on the exercise date minus the exercise price, as this spread was already included as AMT income when exercised.

In a non-qualifying disposition, the spread between the fair market value of the option on the exercise date minus the exercise price is taxed as compensation income subject to the ordinary income tax rates; the remainder of the income is taxed as capital gain income. This capital gain income is then categorized either as short-term gains (if the stock was held one year or less from the exercise date) or as long-term gains (if the stock was held more than one year from the exercise date).

Long-term capital gains are taxed at rates lower than the rates on ordinary income. The following chart shows the income ranges where different tax rates apply to single persons and married couples.

If your filing status is… Then the tax rate applied to …
Single Married Filing Jointly Ordinary Income Long-Term

Capital Gains

& Qualified Dividends

and your taxable income is between… is…
$0 to $9,325 $0 to $18,650 10% 0%
$9,325 to $37,950 $18,650 to $75,900 15% 0%
$37,950 to $91,900 $75,900 to $153,100 25% 15%
$91,900 to $191,650 $153,100 to $233,350 28% 15%
$191,650 to $416,700 $233,350 to $416,700 33% 15%
$416,700 to $418,400 $416,700 to $470,700 35% 15%
$418,400 or more $470,700 or more 39.6% 20%

Tax Move Takeaways

  • If possible, consider exercising ISO when the fair market value of the stock is equal to the strike price, thereby eliminating the AMT income adjustment.
  • If it makes sense from an investment perspective, consider holding the shares long enough to be treated as a qualifying disposition. This way, all the increase in value in the stock will be taxed at the lower capital gains rates.
  • If you leave the company, you have 3 months to exercise any vested ISOs before they expire.
  • If you become disabled and leave your job, you have one year to exercise any vested ISOs before they expire.

Summary of Incentive Stock Options

Grant not a taxable event
Vesting not a taxable event
Exercise Income for AMT increased by FMV of the options on the exercise date minus exercise price, unless the shares are sold in the same year.
Basis Regular tax: Exercise price paid for the shares plus amount included in compensation income from a non-qualifying disposition + brokerage fees and commissions.

AMT: regular basis + FMV of the options on the exercise date minus exercise price.

Special

holding

periods

Qualifying disposition:

  • Holds the stock more than 2 years from the grant date and
  • Holds the stock more than 1 year after the exercise date and
  • Was continuously employed by the employer granting the ISO from the grant date up to 3 months prior to the exercise date
    • (or 1 year before the exercise date if the worker is disabled).

Non-qualifying disposition: any other sale.

Sale or Transfer If qualifying disposition, then:

  • Compensation income is zero.
  • Capital gain = selling price minus adjusted basis.

If non-qualifying disposition, then:

  • Compensation income is FMV of the option when exercised minus the exercise price.
  • (If the ISO shares are sold at a loss, then compensation income is zero.)
  • Compensation income is subject to income tax at ordinary tax rates, but not subject to Social Security and Medicare (FICA).
  • Capital gain income is selling price minus adjusted basis.
  • Basis adjustment is exercise price + compensation income.
  • AMT Basis adjustment: exercise price + compensation income + FMV of the option when exercised over the exercise price. (Thus capital gains will be lower for AMT purposes. This results in a negative AMT adjustment on Line 17 of Form 6251.)

 

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