An additional qualifying criteria is that you must have been continuously employed by the employer granting the ISO from the grant date up to 3 months prior to the exercise date. 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 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.
How Are ISOs Taxed?
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. 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 may not necessarily be paid for through payroll withholding. Taxpayers should send in payments of estimated tax to avoid having a balance due on their tax return.
Reporting Sales of Nonqualified Option Stock -
You may also want to increase the amount of withholding in lieu of making estimated payments. Incentive stock options are reported on Form in three possible ways:. 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 provided by your employer. The calculated spread is reported on Form 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.
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For regular tax purposes, the cost basis of the ISO shares is the price you paid the exercise or strike price. Report the gain on your Schedule D and Form Compensation income is reported as wages on Form line 7, and any capital gain or loss is reported on Schedule D and Form 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 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 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,. For disqualifying dispositions of ISO shares, your cost basis will be the strike price found on Form plus any compensation income reported as wages.
IRS Form is a tax form used to provide employees with information relating to incentive stock options that were exercised during the year. If your company grants you stock options, it simply means they are giving you the opportunity to buy shares of stock in the company at a specific price the exercise price during a specific window of time.
FAQs – Stock Options
To obtain shares of stock under a stock option, the employee must still purchase the stock, which is what differentiates ISOs and NSOs from restricted stock units RSUs. As your ISOs vest become available , you can purchase exercise a certain number of shares at the exercise price. Additionally, ISOs have the potential to yield preferential tax treatment.
ISOs are reported for tax purposes at two different times, when exercised and when sold. How they are taxed when they are sold depends on whether the sale meets the criteria for a qualifying disposition or is considered disqualified. The first reportable event with ISOs occurs when you exercise your options. AMT calculations can get complicated very quickly—so if you are exercising ISOs, speak with your tax advisor first to help you understand the tax implications.
How you are taxed on your gains at sale depends on how long you hold on to your shares. The name of the game is waiting, and how long you wait to sell your shares will determine if you trigger a qualifying or disqualifying disposition. This happens when you wait to sell shares acquired at least one year after you exercised your ISOs and at least two years after they were granted.
If a qualifying disposition is triggered, then any profits you make from the sale of your stock are taxed at long-term capital gains rates. And since long-term capital gains rates are lower than income tax rates, this is where you can realize the benefits of ISOs. If you fail to fulfill either of the waiting period requirements for a qualified disposition, then you have a disqualifying disposition and you lose the tax advantage of long-term capital gains rates.
To compare the impact of a disqualifying disposition, let's use a similar fact pattern to the one above:. Note that both the exercise date and the final sale date are different than those used to illustrate a qualifying disposition. In this example, we meet the first test for a qualifying disposition because the final sale date was more than two years from the grant date. When a disqualifying disposition is triggered, then the bargain element difference between FMV on exercise date and exercise price is taxed as regular income, and the difference between the FMV on the exercise date and the sale date is taxed as capital gain.
As for the capital gain, the rate you pay will depend on whether it is considered a long-term capital gain or a short-term capital gain.
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If held for at least a year, we meet the requirements for the more favorable long-term capital gains rates. If less than a year passed before the sale, then they are considered short-term capital gains and taxed as ordinary income. In our example, we held the shares for 10 months, so they are taxed as short-term capital gains. There are a lot of unknowns when it comes to stocks.
Share prices go up and down all the time, so the longer you hold onto any amount of stock, the more you risk the share prices dropping. The hope is that when you decide to sell your shares, the fair market value of those shares has significantly increased. A strategic approach that considers factors like your cash flow, tax implications and overall portfolio diversification will give you the best chance of seeing the benefit of ISOs. Your advisor can help you develop a strategy for how and when you want to exercise your options.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. No strategy assures success or protects against loss. Throughout his career Jim has helped clients with life planning, coaching them on how to help achieve their vision by leveraging their financial resources and focusing on work-life balance.
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