How and When Are Incentive Stock Options Taxed

Incentive stock options are a form of employee compensation that allows you to participate in the appreciating value of a company’s stock price.  A type of stock option that comes with potentially complicated tax scenarios.

Similar to non-qualified stock options, incentive stock options (ISOs) allows for the purchase of a stock at a predetermined share price. If the current share price of the stock is above the price at which you can exercise your right to buy the share, you have an “in the money” option.

But if the current market price of the stock is below the price at which you can buy the share, you likely pass on your right to exercise the option and buy the shares.

If you find yourself with incentive stock options, it will be helpful to have a working knowledge of how this type of equity compensation is taxed.

Generally speaking, ISOs aren’t taxed until you exercise the option to buy the share – but over the lifespan of an incentive stock option, you may find yourself dealing with several types of taxes along the way.

Taxes on Incentive Stock Options When You Exercise

The first taxable event occurs when you exercise your incentive stock options. When you exercise your incentive stock options, you create a reportable tax event that is based on the spread between the grant price of the option and the fair market value of the stock when you exercise, multiplied by the number of options you exercise.

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For example, let’s assume you have the following:

• 10,000 ISOs
• $1.00 grant price
• $25.00 fair market value at exercise

In this example, the $24 spread between the grant price and the fair market value at exercise multiplied by 10,000 shares is $240,000.

This amount is known as the bargain element. The type of tax you may pay on the bargain element depends on what you do next.

The Difference Between Qualifying vs. Disqualifying Disposition of Incentive Stock Options

Incentive stock options are often preferred to non-qualified stock options because you have the potential to pay long term capital gains rates on the bargain element of the stock should you meet specific holding requirements:

1. The final sale of the stock must be at least 2 years from the grant date, AND
2. The final sale of the stock must be at least 1 year from the exercise date.

Should you meet these requirements, the bargain element and future gain get taxed at preferential rates. This is known as a qualifying disposition.

If you don’t meet the requirements you have a disqualifying disposition and the bargain element will be taxed as ordinary income. It won’t be subject to Social Security and Medicare wage tax (I point this out as a difference between NSOs and ISOs. NSOs are subject to Social Security and Medicare wage tax).

Tax on a Disqualifying Disposition of Incentive Stock Options

Let’s assume you immediately exercise and sell the shares from our hypothetical example above. In this scenario, you turned stock options into cash you can use for personal expenses or allocate to savings.

The rules of a disqualifying disposition state that the bargain element will be treated as ordinary income. If we assume a flat 35% tax bracket, we can assume you will pay $84,000 in tax on your exercise and sell of $240,000 worth of incentive stock options.

Tax on a Qualifying Disposition of Incentive Stock Options

Continuing the above example and assuming you exercise and hold your ISOs, the tax implications become increasingly more complicated. You may be subject to the alternative minimum tax, or AMT, and long-term capital gains rates (assuming you realized a profit gain when you sell).

AMT is the result of a secondary tax calculation that occurs every year when you file your tax return. As a taxpayer, you generally pay the higher of the regular tax calculation or the tentative minimum tax calculation. The difference you pay if the tentative minimum tax is higher is the AMT.

When you exercise and hold incentive stock options past the calendar year-end, no earned income is reported on your W2. Your adjusted gross income on your regular tax calculation won’t change.

But the bargain element is a tax preference item for calculating the tentative minimum tax. This means that if you exercise and hold incentive stock options, it’s possible that this tentative minimum tax calculation may be the higher of the two. If it is, you’re required to pay that amount instead.

Following the example above, let’s assume the same situation and an AMT tax rate of 28%:

• 10,000 ISOs
• $1.00 grant price
• $25.00 fair market value at exercise

In this scenario, the $240,000 bargain element will result in a tentative minimum tax of $67,200.

If your tentative minimum tax is higher than your regular tax, you may owe the higher of the two. A tentative minimum tax that is the higher of the two is often a direct result of the exercise and hold of ISOs.

Eventually, you’ll probably sell the ISOs you exercised and held. If you sell your shares as a qualifying disposition, you’ll pay long-term capital gains on the entire amount from the original grant price of the stock to the final sales price.

Continuing our example from above, let’s assume that since you exercised the shares, the share price has increased from $25 per share to $65 per share.

• 10,000 ISOs
• $1.00 grant price
• $25.00 fair market value at exercise
• $65.00 final sale price

Assuming a qualifying disposition, the amount from $1 per share to $65 per share should be taxed at long-term capital gains rates. This gain is $640,000. Assuming a flat 15% tax bracket, you will be subject to $96,000 in capital gains tax.

Alternative Minimum Tax Credits

If you are following the above scenario, you may have noticed that you have in fact paid tax twice on a certain portion of the hypothetical example:

1. You paid the AMT in the year of exercise on the amount between $1 and $25, and
2. You paid LTCG on the amount between $1 and $25 when you sold the shares

Clearly, this would be a disadvantageous tax scenario. Enter the AMT credit.

When you sell your incentive stock option shares in a final sale, you may be able to receive some of the  AMT paid back as a credit. This is calculated on your tax return by looking at the difference between regular capital gains and AMT capital gains.  This calculation may allow you to receive an AMT credit to cover the tax you already paid.

Said another way, when you sell your shares, you may get some or all of the money you paid on AMT when you exercised and held back to you.

This explains why much of the attention surrounding incentive stock options centers around AMT. A significant AMT bill may be a reason (or not) to exercise your shares. It should certainly be a reason to consider what your options strategy may be.

Other Advanced Tax Considerations to Remember

In addition to AMT, you may want to think about long-term capital gains. Long-term capital gains may be taxed as low as 0% — or they could be taxed at 15%, or even as high at 20% when your income exceeds certain amounts.

When planning for your final sale of stock, it is important to understand what other income you have and how much room you have in various capital gains tax brackets.

For example, one strategy may be to “fill up” your 15% capital gains tax bracket. You can run detailed tax projections to determine how much capital gains you can incur, therefore determining how much stock you can sell, so you only pay 15% capital gains tax.

To do this calculation well, it may take the resources of a good accountant or financial advisor. When considering you could pay far less in tax by getting these complicated decisions correct, it may be well worth hiring a professional to help you.

You may also need to deal with the net investment income tax (NIIT). This tax is paid on capital assets (which are likely the shares of company stock you sell) when your adjusted gross income exceeds $250,000 (for married filing jointly in 2020).

The amount in excess of $250,000 is taxed at 3.8%. If we combine the NIIT with the highest capital gains bracket above (20% + 3.8%), you can see that your long-term capital gains may be taxed as high as 23.8%.

And while not exactly a direct tax in the same sense as long-term capital gains and net investment income tax, you should still pay attention to how AMT is calculated and how it impacts how much tax you pay.

What to Know About How Incentive Stock Options are Taxed

You may face many different types of taxes owed when you have incentive stock options. The timing of your exercise, hold, and final sale of the stock options can only further intensify the difficulty in understanding which of those taxes apply and what moves to make to reduce your bill.

Unfortunately, this complexity and uncertainty often lead to inaction because people feel afraid of the unknown — or they’re afraid of making a mistake.

If you find yourself with incentive stock options, begin learning about the tax you may pay and when. If you are not prepared to handle that on your own, it may make sense to work with someone who is an expert in tax and other financial planning needs that can arise.

Knowing the rules and planning a good exercise strategy for your incentive stock options can lead to a material difference in the amount you receive in the end.

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. Hypothetical examples contained herein are for illustrative purposes only and do not reflect, nor attempt to predict, actual results of any investment. 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. Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions.