Incentive Stock Options

Tax treatment of incentive stock options (ISO)

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Incentive stock options are a form of compensation to employees in the form of stock rather than cash. With an incentive stock option (ISO), the employer grants to the employee an option to purchase stock in the employer's corporation, or parent or subsidiary corporations, at a predetermined price, called the exercise price or strike price. Stock can be purchased at the strike price as soon as the option vests (becomes available to be exercised).

Strike prices are set at the time the options are granted, but the options usually vest over a period of time. If the stock increases in value, an ISO provides employees with the ability to purchase stock in the future at the previously locked-in strike price. This discount in the purchase price of the stock is called the spread. ISOs are taxed in two ways: on the spread and on any increase (or decrease) in the stock's value when sold or otherwise disposed. Income from ISOs are taxed for regular income tax and alternative minimum tax, but are not taxed for Social Security and Medicare purposes.

In order to calculate the tax treatment of ISOs, you'll need to know:

  • Grant date: the date the ISOs were granted to the employee
  • Strike price: the cost to purchase a share of stock
  • Exercise date: the date on which you exercised your option and purchased shares
  • Selling price: the gross amount received from selling the stock
  • Selling date: the date on which the stock was sold.
How ISOs are taxed depends on how and when the stock is disposed. Disposition of stock is typically when the employee sells the stock, but it can also include transferring the stock to another person or giving the stock to charity.

Qualifying dispositions of incentive stock options

A qualifying disposition of ISOs simply means that the stock, which was acquired through an incentive stock option, was disposed more than two years from the grant date and more than one year after the stock was transferred to the employee (usually the exercise date).
There's an additional qualifying criteria: the taxpayer must have been continuously employed by the employer granting the ISO from the grant date up to 3 months prior to the exercise date.

Tax treatment of exercising incentive stock options

Exercising an ISO is treated as income solely for the purpose of calculating the alternative minimum tax (AMT), but is ignored for the purpose of calculating the regular federal income tax. The spread between the fair market value of the stock and the option's strike price is included as income for AMT purposes. The fair market value is measured on the date when the stock first becomes transferable or when your right to the stock is no longer subject to a substantial risk of forfeiture. This inclusion of the ISO spread in AMT income is triggered only if you continue to hold the stock at the end of the same year in which you exercised the option. If the stock is sold within the same year as exercise, then the spread does not need to be included in your AMT income.

Tax treatment of a qualifying dispositions of incentive stock options

A qualifying disposition of an ISO is taxed as a capital gain at the long-term capital gains tax rates on the difference between the selling price and the cost of the option.

Tax treatment of disqualifying dispositions of incentive stock options

A disqualifying or nonqualifying disposition of ISO shares is any disposition other than a qualifying disposition.
Disqualifying ISO dispositions are taxed in two ways: there will be compensation income (subject to ordinary income rates) and capital gain or loss (subject to the short-term or long-term capital gains rates).

The amount of compensation income is determined as follows:

  • if you sell the ISO at a profit, then your compensation income is the spread between the stock's fair market value when you exercised the option and the option's strike price.
  • Any profit above compensation income is capital gain.
  • If you sell the ISO shares at a loss, the entire amount is a capital loss and there's no compensation income to report.

Withholding and Estimated Taxes

Be aware that employers are not required to withhold taxes on the exercise or sale of incentive stock options. Accordingly, persons who have exercised but not yet sold ISO shares at the end of the year may have incurred alternative minimum tax liabilities. And persons who sell ISO shares may have significant tax liabilities that aren't paid for through payroll withholding. Taxpayers should send in payments of estimated tax to avoid having a balance due on their tax return. You may also want to increase the amount of withholding in lieu of making estimated payments.

Incentive stock options are reported on Form 1040 in various possible ways. How incentive stock options (ISO) are reported depends on the type of disposition. There are three possible tax reporting scenarios:

Reporting the exercise of incentive stock options and the shares are not sold in the same year

Increase your AMT income by the spread between the fair market value of the shares and the exercise price. This can be calculated using data found on Form 3921 provided by your employer. First, find the fair market value of the unsold shares (Form 3921 box 4 multiplied by box 5), and then subtract the cost of those shares (Form 3921 box 3 multiplied by box 5). The result is the spread, and is reported on Form 6251 line 14.

Because you are recognizing income for AMT purposes, you will have a different cost basis in those shares for AMT than for regular income tax purposes. Accordingly, you should keep track of this different AMT cost basis for future reference. For regular tax purposes, the cost basis of the ISO shares is the price you paid (the exercise or strike price). For AMT purposes, your cost basis is the strike price plus the AMT adjustment (the amount reported on Form 6251 line 14).

Reporting a qualifying disposition of ISO shares

Report the gain on your Schedule D and Form 8949. You'll report the gross proceeds from the sale, which will be reported by your broker on Form 1099-B. You'll also report your regular cost basis (the exercise or strike price, found on Form 3921). You'll also fill out a separate Schedule D and Form 8949 to calculate your capital gain or loss for AMT purposes. On that separate schedule you'll report gross proceeds from the sale and your AMT cost basis (exercise price plus any previous AMT adjustment). On Form 6251, you'll report a negative adjustment on line 17 to reflect the difference in gain or loss between the regular and AMT gain calculations. Refer to the Instructions for Form 6251 for details.

Reporting a disqualifying disposition of ISO shares

Compensation income is reported as wages on Form 1040 line 7, and any capital gain or loss is reported on Schedule D and Form 8949. Compensation income may already be included on your Form W-2 wage and tax statement from your employer in the amount shown on box 1. Some employers will provide a detailed analysis of your box 1 amounts at the top portion of your W-2. If the compensation income has already been included on your W-2, then simply report your wages from Form W-2 box 1 on your Form 1040 line 7. If the compensation income has not already been included on your W-2, then calculate your compensation income, and include this amount as wages on line 7, in addition to the amounts from your Form W-2. On your Schedule D and Form 8949, you'll report the gross proceeds from the sale (shown on Form 1099-B from your broker) and your cost basis in the shares. For disqualifying dispositions of ISO shares, your cost basis will be the strike price (found on Form 3921) plus any compensation income reported as wages. If you sold the ISO shares in a year other than the year in which you exercised the ISO, you will have separate AMT cost basis, so you'll utilize a separate Schedule D and Form 8949 to report the different AMT gain and you'll use Form 6251 to report a negative adjustment for the difference between the AMT gain and the regular capital gain.

Form 3921 is a tax form used to provide employees with information relating to incentive stock options that were exercised during the year. Employers provide one instance of Form 3921 for each exercise of incentive stock options that occurred during the calendar year. Employees who had two or more exercises may receive multiple Forms 3921 or may receive a consolidated statement showing all exercises.

The formatting of this tax document may vary, but it will contain the following information:

  • identity of the company that transferred stock under an incentive stock option plan,
  • identity of the employee who exercise the incentive stock option,
  • date the incentive stock option was granted,
  • date the incentive stock option was exercised,
  • exercise price per share,
  • fair market value per share on the exercise date,
  • number of shares acquired,
This information can be utilized to calculate your cost basis in the shares, to calculate the amount of income that needs to be reported for the alternative minimum tax, and to calculate the amount of compensation income on a disqualifying disposition, and to identify the beginning and end of the special holding period to qualify for preferred tax treatment.

Identifying the Qualifying Holding Period

Incentive stock options have a special holding period to qualify for capital gains tax treatment. The holding period is two years from the grant date and one year after the stock was transferred to the employee. Form 3921 shows the grant date in box 1 and shows the transfer date or exercise date in box 2. Add two years to the date in box 1 and add one year to the date in box 2.

If you sell your ISO shares after whichever date is later, then you will have a qualifying disposition and any profit or loss will be entirely a capital gain or loss taxed at the long-term capital gains rates.

If you sell your ISO shares anytime before or on this date, then you'll have a disqualifying disposition, and the income from the sale will be taxed partly as compensation income at the ordinary income tax rates and partly as capital gain or loss.

Calculating Income for the Alternative Minimum Tax on Exercise of an ISO

If you exercise an incentive stock option and don't sell the shares before the end of the calendar year, you'll report additional income for the alternative minimum tax (AMT). The amount included for AMT purposes is the difference between the fair market value of the stock and the cost of the incentive stock option. The fair market value per share is shown in box 4. The per-share cost of the incentive stock option, or exercise price, is shown in box 3. The number of shares purchased is shown in box 5. To find the amount to include as income for AMT purposes, multiply the amount in box 4 by the amount of unsold shares (usually the same as reported in box 5), and from this product subtract exercise price (box 3) multiplied by the number of unsold shares (usually the same amount shown in box 5).
Report this amount on Form 6251, line 14.

Calculating Cost Basis for Regular Tax

The cost basis of shares acquired through an incentive stock option is the exercise price, shown in box 3. Your cost basis for the entire lot of shares is thus the amount in box 3 multiplied by the number of shares shown in box 5. This figure will be used on Schedule D and Form 8949.

Calculating Cost Basis for AMT

Shares exercised in one year and sold in a subsequent year have two cost bases: one for regular tax purposes and one for AMT purposes. The AMT cost basis is the regular tax basis plus the AMT income inclusion amount. This figure will be used on a separate Schedule D and Form 8949 for AMT calculations.

Calculating Compensation Income Amount on a Disqualifying Disposition

If incentive stock option shares are sold during the disqualifying holding period, then some of your gain is taxed as wages subject to ordinary income taxes, and the remaining gain or loss is taxed as capital gains. The amount to be included as compensation income, and usually included on your Form W-2 box 1, is the spread between the stock's fair market value when you exercised the option and the exercise price. To find this, multiply the fair market value per share (box 4) by the number of shares sold (usually the same amount in box 5), and from this product subtract exercise price (box 3) multiplied by the number of shares sold (usually the same amount shown in box 5). This compensation income amount is typically included on your Form W-2, box 1. If it's not included on your W-2, then include this amount as additional wages on Form 1040 line 7.

Calculating Adjusted Cost Basis on a Disqualifying Disposition

Start with your cost basis, and add any amount of compensation. Use this adjusted cost basis figure for reporting capital gain or loss on Schedule D and Form 8949.

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