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: Income from ISOs are taxed for regular income tax and alternative minimum tax, but are not taxed for Social Security and Medicare purposes. 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. 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: 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. 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. A disqualifying or nonqualifying disposition of ISO shares is any disposition other than a qualifying disposition. Disqualifying ISO dispositions are taxed in two ways: 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 in various possible ways. How incentive stock options ISO are reported depends on the type of disposition. There are three possible tax reporting scenarios:. 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. Form 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 for each exercise of incentive stock options that occurred during the calendar year.
Employees who had two or more exercises may receive multiple Forms or may receive a consolidated statement showing all exercises. The formatting of this tax document may vary, but it will contain the following information:. 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.
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 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.
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 , line 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 Shares exercised in one year and sold in a subsequent year have two cost bases: 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 line 7. 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 Updated July 07, Calculating Adjusted Cost Basis on a Disqualifying Disposition Start with your cost basis, and add any amount of compensation.More...