A Quick Take on the Tax Treatment of Incentive Stock Options

If your employer has granted you incentive stock options (ISOs), you’ve likely spent time researching the tax treatment. If so, you’ve probably read about the alternative minimum tax (AMT), and qualifying and disqualifying dispositions. Perhaps the complication has left you wondering: What does this mean to me as a taxpayer?

While AMT and holding periods for qualified sales may be important from a tax-reporting standpoint, they may be irrelevant if you simply exercise and sell your ISOs in a cashless transaction. So, before you spend too much time studying the nuances, you might want to ground yourself on other key points regarding the tax treatment of ISOs.

Getting started, here’s the quick take, based on key events on the ISO timeline:

While that sums up the key factors, it’s important that we dig into the details.

AMT Considerations When You Exercise Your ISOs

When you exercise your ISOs, there is no direct reporting for regular tax purposes. There is a reportable event, however, for figuring the AMT.

A Note on AMT: Think of AMT as a pre-payment of tax, which is often returned as a tax credit in future years, particularly in years when qualified ISOs are sold. Therefore, paying AMT may be okay, and even the best move, if the stock price stays level or increases in value.  But it may require cash to cover AMT for the year of exercise.

If you exercise and hold your incentive stock options beyond the calendar year-end, you figure whether you owe AMT by adjusting for the bargain element—which is the spread between your ISO strike price and the stock’s fair market value (FMV) at exercise.

If you exercise and sell your ISO prior to year-end, no adjustment is required for figuring AMT (assuming no placement shares are purchased).

This is important from a year-end planning perspective, particularly if you exercise ISO early in the calendar year at one price, and the stock price by year-end is significantly lower.

For a more thorough discussion on AMT payments and credits, we recommend our companion post: 6 Tips to Manage and Mitigate the AMMT on ISOs. One tip to emphasize here:

Avoiding AMT: If you complete an exercise and disqualified disposition in a single calendar year, you may be able to avoid AMT. If you do the same across two calendar years, you will need to report an AMT adjustment in the exercise year. This might be particularly interesting in a year when the stock price decreases post-exercise.

Selling your Previously Exercised Incentive Stock Options

AMT aside, most of the taxable action happens after you’ve sold your exercised ISO shares. When you do, the sale is either a qualified or disqualified sale, and is taxed accordingly.

Tax Treatment of a Qualified Sale

If you’ve held your exercised shares at least two years after your grant date AND one year after you exercised them, the sale is qualified, and taxed at generally more favorable long-term capital gain rates.

For qualified sales, if your final sale price is higher than the strike price at which you were granted your options, the realized profit is taxed as a capital gain. If the final sale press is less than the strike price, you can report it as a capital loss.

Qualified Sale Summary: Any income from a qualified sale is taxed at generally more favorable capital gain rates; any losses can be used to offset capital gains, and ordinary income (up to annual limits, but carrying over to future years).

In addition to preferential long-term capital gains on the stock sale, you may also receive AMT credit in the year you sell qualified ISOs. More specifically, the difference between regular capital gains and AMT capital gains is an adjustment when figuring AMT. In years when you sell qualified ISOs, you may be able to accelerate your AMT credits.

Tax Treatment of a Disqualified Sale

If you sell your exercised shares before the qualifying timeframes just described, the sale is disqualified, and may be taxed as a blend of ordinary income and capital asset rates. It depends whether you’re selling your shares for above or below their FMV at exercise (or below the strike price itself). While the information below may help you understand some of the concepts, it is strongly encouraged to consult with a tax professional about your specific situation.   

Above FMV at Exercise: If you sell shares for more than their FMV at exercise, you’ll incur:

• Ordinary income: The difference between your strike price and the FMV at exercise is taxed as ordinary income; AND
• Capital gains: The difference between your final sale price and the FMV at exercise is taxed as a capital gain.

Below FMV at Exercise and Above Strike Price: If you sell shares for more than their strike price but less than their FMV at exercise, you’ll incur ordinary income tax on the difference between your final sale price and the option’s strike price.

That’s a lot to wrap your head around, so let’s illustrate how to calculate taxes on a disqualified sale. We’ll begin with the following assumptions:

• At Grant: You’re granted 1,000 incentive stock options at a strike price of $5/share.

Your regular cost basis is 1,000 shares x $5/share = $5,000

• At Exercise: You exercise all your stock options when their FMV is $50/share.

Your AMT cost basis is 1,000 shares x $50/share = $50,000

Now, let’s consider the tax ramifications of making a disqualified sale above and below the $50,000 FMV at exercise.

Scenario #1: A Disqualified Sale ABOVE Fair Market Value at Exercise

At Sale: You sell all your stock options within a year of exercise, when their FMV is $75/share.

• Your disqualified final sale proceeds are 1,000 shares x $75/share = $75,000
• Your total taxable gain is $75,000 – $5,000 strike price = $70,000

Calculating Taxable Ordinary Income: You incur ordinary income taxes on the FMV at exercise, less the strike price. This amount is included on your W-2 and taxed as ordinary income (not subject to Social Security or Medicare tax).

• $50,000 – $5,000 = $45,000 taxed as ordinary income

Calculating Taxable Capital Gains: You incur capital gains taxes on the final sale value minus FMV at exercise.

• $75,000 – $50,000 = $25,000 taxed as capital gains

Disqualified Sale Summary Scenario #1: Out of a $70,000 total taxable gain, you’ll incur ordinary income taxes on $45,000 of income, and capital gains taxes on $25,000 of income.

Scenario #2: A Disqualified Sale BELOW Fair Market Value at Exercise (and above the strike price)

At Sale: You sell all your stock options within a year of exercise, when their FMV is $30/share (which is less than the FMV at exercise, but more than your strike price).

• Your disqualified final sale proceeds are 1,000 shares x $30/share = $30,000
• Your total taxable gain is $30,000 – $5,000 = $25,000

Calculating Taxable Ordinary Income: You incur ordinary income taxes on the FMV at sale, less the strike price. This amount is included on your W-2 and taxed as ordinary income (not subject to Social Security or Medicare tax).

• $30,000 – $5,000 = $25,000 taxed as ordinary income

Calculating Taxable Capital Gains: You incur no capital gain or loss on the final sale of ISO in this example. In this example, your regular cost basis of the stock equals the value paid ($5,000) + the value included in your W-2 ($25,000)

• $30,000 – $30,000 = $0

Disqualified Sale Summary Scenario #2: Out of the $25,000 final sale proceeds, you’ll incur ordinary income tax rates on $25,000 of income, and no capital gain or loss.

If you complete a disqualified sale in the same calendar year, no adjustment is made for AMT.  If the transactions span two calendar years, you’ll need to adjust for AMT in the year of exercise. You’ll pay ordinary income tax rates in the year you sell the stock (assuming you have a profit) and adjust for potential AMT credits in the year of sale and beyond.

A Note on Tax Planning: In a disqualified disposition of ISO, no income tax is withheld when you sell.  So, while you receive the full proceeds of the sale, it would be wise to plan for potential tax due.  This might mean allocating a portion of the sale proceeds to cover tax due, including possibly making estimated tax payments.

Reporting the Tax of Incentive Stock Options

Now that we’ve summarized the tax treatment of your Incentive Stock Options, let’s review how to report the results on your tax returns. Keep in mind this is a guide, and you should consult your tax professional for how this may impact you.

For an Exercise and Hold of ISO (no sale): You should receive a Form 3921 from your employer, which you’ll use to report the event in the calendar year you exercise your options. This information flows through to Form 6251 to calculate any potential AMT due.

For a Qualified Sale: Report the event in the calendar year of the sale. You should receive a Form 1099B from your custodian to help you and your accountant calculate your regular capital gains and losses. You’ll also likely need to figure AMT gains and losses to figure the AMT credit.

For a Disqualified Sale: Depending on the final sale price, your employer may report some or all of the profit as ordinary income on your Form W-2 in the year of the sale. You should also receive a Form 1099B from the brokerage firm that completed the transaction.

Tax Treatment Isn’t All About the Taxes

It’s important to manage the tax impact of your ISO benefits. But minding your exposure to concentrated stock risks may be even more important. This means you might decide to take a full or partial disqualified sale on exercised ISOs, even if it means being taxed at higher rates.

As we commented in our previous post, Considering Your Incentive Stock Options:

“By taking a qualified disposition, you’re also taking on a concentrated [stock] risk. If the stock price drops in the year or so after you exercise your options but before you sell the stock, you may lose more in share value than any tax savings are worth.”

To avoid letting the tax tail wag your wealth dog, it might help to think of your stock options as simply more pay for services rendered. Even worst case, the tax rates on your ISOs will never be any higher than the ones you pay on your regular paycheck. If you frame it like that, it should be easier to decide what’s really best for you and your equity compensation.

Next Steps

As you can see, even a quick take on ISO tax planning yields considerable food for thought. Rather than try to digest it on your own, we suggest sharing the bounty with someone who specializes in equity compensation planning. Give us a call if we can help you more closely consider the ideal tax treatment on your Incentive Stock Options.

This material is intended for informational/educational purposes only and should not be construed as investment, tax, or legal advice, a solicitation, or a recommendation to buy or sell any security or investment product. The information contained herein is taken from sources believed to be reliable, however accuracy or completeness cannot be guaranteed. Please contact your financial, tax, and legal professionals for more information specific to your situation.