Note: If you are unfamiliar with stock options, then you probably should read this post before moving on.
Incentive stock options (or ISOs for short) are not as common as nonqualified stock options. But they do have special tax features that can be particularly beneficial for the employee.
When you are granted an ISO, you do not owe any taxes. Even if the option vests and you do not exercise it, there is still no tax.
Generally, you will owe taxes on ISOs when you either exercise the option or sell the stock after exercising the option. Depending on the circumstances, the taxes may be based on the alternative minimum tax, ordinary income or capital gains.
So how do you know if the option is an ISO? Of course, you should ask your company! But here are some of the rules for your reference:
- Option Plan. An ISO must be granted in accordance with a company option plan, which sets forth the basic terms and policies.
- Length. An employee may not exercise an ISO later than 10 years after the option grant. If the holder owns more than 10% of the company’s voting stock, then the time frame is five years.
- Exercise Price. It cannot be lower than the current fair market value (FMV) at the time of the grant. If the employee owns more than 10% of the voting stock of the company, then the minimum exercise price is 110% of the current FMV.
- Employment. ISOs can be issued only to people who are company employees. If the employee leaves, he or she has up to three months to exercise any vested options (but a company can shorten this period).
- $100,000 rule. You may not exercise an option that has a value over $100,000 for any year. If there is an excess, then this is treated as a nonqualified option.
When you exercise an ISO, you do not have to pay any federal taxes. But this does not mean Uncle Sam will not want money!
Keep in mind that the exercise may trigger the alternative minimum tax (AMT). Congress established this system, over 40 years ago, as a way to make sure high-income people pay their fair share. However, as time has gone by, the AMT has actually affected more and more taxpayers. And yes, if you have an ISO, you will need to understand how the AMT works. But the rules are extremely complicated and it certainly a good idea to get expert help.
Given this, some people will exercise and shortly after, sell the shares from their ISO. This will result in a “disqualifying disposition.” True, it sounds scary. But this is tax mumbo-jumbo for when an ISO turns into a nonqualified option.
The tax implications involve the following:
- If you sell the shares for lower than the value you paid for them, you have a capital loss
- If you sell the shares for a profit but at a value no larger than the FMV at the time of the exercise, you will have a gain that is treated as ordinary income.
- If the profit is higher than the value at the time of the exercise, then there are two things you need to do. First, you will recognize ordinary income for the value you realized at the time of the exercise. Next, anything above this will be treated as a capital gain (this will probably be classified as short-term).
- The employer will not take any withholding. However, this means you will probably have to make estimated payments to cover the tax liability.
Interestingly enough, there are certain actions – other then selling stock – that may trigger a disqualifying disposition. They include:
- Gifts of stock (other than to a spouse or because of death)
- Transfer of the stock under the Uniform Transfers to Minor Act
- Transfer to an irrevocable trust
- Short sells of the company stock
But there is no disqualifying disposition when there is:
- Personal bankruptcy
- Margin from your broker (borrowing money against your shares)
- Transfer of shares into a brokerage account
OK, then why would anyone want to hold onto the shares? The reason is that there is a big-time potential tax benefit: You may be eligible to get the preferential long-term capital gains tax rate, which is at a maximum of 20% (this compares to 39.6% for ordinary rates).
To get this, you must meeting the following:
- You exercised the option more than two years after the grant
- You did not sell the shares until over one year after the exercise