Incentive stock options (ISOs) are a type of employee compensation in the form of stock rather than cash. With an incentive stock option (ISO), the employer grants 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 time.
If the stock increases in value, the ISO allows the employee to purchase stock in the future at the previously locked-in strike price.1 This discount on 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.2 The income from ISOs is subject to regular income tax and alternative minimum tax, but it is not taxed for Social Security and Medicare purposes.
To calculate the tax treatment of an ISO, you will need the following information.
- The grant date: The date the ISO was granted
- The strike price: The cost to purchase a share of stock
- The exercise date: The date on which the option was exercised and shares purchased
- Selling price: The gross amount received from selling the stock
- Selling date: The date on which the stock was sold3
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 stock can also be transferred to another person or donated to charity.
Qualifying Dispositions of Incentive Stock Options
A qualifying disposition for an ISO simply means that the stock acquired is 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 is an additional qualifying criterion: the taxpayer must have been continuously employed by the employer granting the ISO from the grant date up to three months prior to the exercise date.4
Tax Treatment for Incentive Stock Options
Exercising an ISO is treated as income solely for the purposes of calculating alternative minimum tax (AMT), but it is ignored for the purposes of calculating regular federal income tax.5 The spread between the fair market value of the stock and the option’s strike price is considered income for AMT purposes. The fair market value is measured on the date when the stock first becomes transferable or when the employee’s 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 the employee continues to hold the stock at the end of the same year in which the option was exercised.
If the stock is sold within the same year as its exercise, then the spread does not need to be included in AMT income.6
Tax Treatment for Qualifying Dispositions of Incentive Stock Options
A qualifying disposition for an ISO is taxed as a capital gain at long-term capital gains tax rates and on the difference between the selling price and the cost of the option.6
Tax Treatment of Disqualifying Dispositions of Incentive Stock Options
A disqualifying or non-qualifying disposition of ISO shares is any disposition other than a qualifying disposition. Disqualifying ISO dispositions are taxed in two ways: 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 the ISO is sold at a profit, the compensation income is the spread between the stock’s fair market value when the option was exercised and the option’s strike price.
- Any profit above compensation income is capital gain.
- If the ISO shares are sold at a loss, the entire amount is a capital loss, and there is no compensation income to report.6
Withholding and Estimating Taxes
Be aware that employers are not required to withhold taxes on the exercise or sale of incentive stock options. Accordingly, those who have exercised but not yet sold ISO shares at the end of the year may have incurred alternative minimum tax liabilities. Additionally, those who sell ISO shares may have significant tax liabilities not covered by payroll withholding. Taxpayers should send in estimated tax payments to avoid having a balance due on their tax return. Taxpayers may also want to increase the amount of withholding in lieu of making estimated payments.6
ISOs are reported on Form 1040.7 How they are reported depends on the type of disposition. There are three possible tax reporting scenarios.
Reporting the Exercise of Incentive Stock Options and Shares Not Sold in the Same Year
In this case, AMT income is increased 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 their 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).8 The result is the spread and this is reported on Form 6251, line 14.9
Because income is being recognized for AMT purposes, there is a different cost basis in the shares for AMT than the shares for regular income tax purposes. It is advisable to 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 paid (the exercise or strike price). For AMT purposes, the 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
The gain should be reported on Schedule D and Form 8949. The gross proceeds from the sale are required, which are given by the broker on Form 1099-B. Also required to be reported is the regular cost basis (the exercise or strike price, found on Form 3921). A separate Schedule D and Form 8949 should be completed to calculate the capital gain or loss for AMT purposes.10 11 On the separate schedule, report gross proceeds from the sale and the AMT cost basis (exercise price plus any previous AMT adjustment). On Form 6251, there will be 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.9
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 Form W-2, the wage and tax statement from the employer in the amount shown in box 1. Some employers will provide a detailed analysis of the box 1 amounts at the top portion of the W-2. If the compensation income has already been included on the W-2, then simply report wages from Form W-2 box 1 on Form 1040, line 7. If the compensation income has not already been included on the W-2, then calculate compensation income and include this amount as wages on line 7 in addition to the amounts from Form W-2.12 13
On Schedule D and Form 8949, report the gross proceeds from the sale (shown on Form 1099-B from the broker) and the cost basis for the shares.11 10 For disqualifying dispositions of ISO shares, the cost basis will be the strike price (found on Form 3921) plus any compensation income reported as wages. If the ISO shares were sold in a year other than the year in which the ISO was exercised, the cost basis will be different and a separate Schedule D and Form 8949 should report the different AMT gain. Use Form 6251 to report a negative adjustment for the difference between the AMT gain and the regular capital gain.9
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 ISOs that occurred during the calendar year. Employees who had two or more exercises may receive multiple Forms 3921 or a consolidated statement showing all exercises. The formatting of this tax document may vary, but it will contain the following information:
- The identity of the company that transferred stock under the ISO
- The identity of the employee who exercised the ISO
- The date the incentive stock option was granted
- The date the incentive stock option was exercised
- The exercise price per share
- The fair market value per share on the exercise date
- The number of shares acquired
This information is used to calculate the cost basis for the shares, the amount of income that needs to be reported for the alternative minimum tax, 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.8
Identifying the Qualifying Holding Period
ISOs 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 2.8
If the ISO shares are sold after whichever date is later, that is a qualifying disposition and any profit or loss will be a capital gain or loss taxed at the long-term capital gains rates. If the ISO shares are sold anytime before or on this date, that is a disqualifying disposition, and the income from the sale is 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 the Exercise of an ISO
If an ISO is exercised and the shares are not sold before the end of the calendar year, report additional income for the 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 of Form 3921. 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 number of unsold shares (usually the same as reported in box 5) and, from this product, subtract the 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 14.9
Calculating the Cost Basis for Regular Tax
The cost basis of shares acquired through an incentive stock option is the exercise price, shown in box 3. The cost basis for the entire lot of shares is 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 8949.10 11
Calculating the 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.10 11
Calculating Compensation Income Amount on a Disqualifying Disposition
If ISO shares are sold during the disqualifying holding period, some of the 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 typically included on 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 the 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 Form W-2, box 1.12 If it is not included on the W-2, include this amount as additional wages on Form 1040, line 7.13
Calculating the Adjusted Cost Basis of a Disqualifying Disposition
Start with the cost basis and add any amount of compensation. Use this adjusted cost basis figure to report capital gain or loss on Schedule D and Form 8949.
-William Perez the balance careers