ISOs - Exercising

The Incentive Stock Option (ISO) grant is classified by the IRS as eligible for special tax treatment. This enables holders to pay taxes only once - at the point of sale - as opposed to twice (at the point of exercise and the point of sale) as is the case with Non-qualified Stock Options (NSOs).

Even though this special tax treatment exists, the holder of the ISO must meet certain requirements to receive this benefit. If the requirements are met, the holder will pay long-term capital gains taxes which makes it ultimately more tax efficient than the NSO.

Another important thing to note that will affect your tax basis when exercising your ISOs is the Alternative Minimum Tax (AMT). AMT will come into play depending on how large the spread is between the fair market value and the exercise price of the grant. We have a full article on AMT here

At the point of exercise, ISO grant holders will pay a predetermined price (the exercise price) and acquire shares in the company. Typically, when this occurs, the fair market value (FMV) is higher than the exercise price. The price difference between the FMV and the exercise price is added to the holder’s income for the purposes of calculating the holder’s AMT, a tax designed for high income earners. The larger the spread, the greater amount of income added to AMT.

ISOs – Disposing of Stock

The difference between the selling price and the cost basis (the exercise price paid for the stock) is what the IRS uses to determine the capital gain on an exercise. ISOs, despite their potential for favorable tax treatment, may still have two different points of taxation and therefore two different components: capital gains income and compensation income.

The sale of stock is a qualifying disposition (i.e. will not trigger a second taxable point) if the holder:

• Holds the stock for more than two years from the grant date
• Holds the stock for more than one year after the point of exercise
• Was employed the by the grant issuing employer from the point of grant date to up to three months prior to the exercise date

If the disposition is qualifying (meaning that it meets all of the above requirements), then the difference between the selling price and the cost basis (the price paid for the stock) is treated as long-term capital gains. Additionally, if the holder is subject to AMT for the transaction, then the cost basis is reduced to reflect the FMV less the exercise price component calculated previously.

If the disposition is non-qualifying (meaning that it does not meet one or more of the above requirements), then the spread between the FMV and the exercise price is taxed at the ordinary income rate.

The remaining difference between the disposition price and the cost basis (which is the FMV) is then treated as capital gains. It will further be considered as either short-term or long-term capital gains depending on the amount of time the shares were held.

If the shares were held for longer than one year, then the remainder is taxed at the long-term capital gains rate, and if it was less than one year the short-term capital gains rate applies (which is higher, but the same as the ordinary income rate).

We know, it’s a lot of terms and acronyms, so we’ll give you a couple of examples to iron out any confusion:

In this case the sale is categorized as a qualified disposition since the shares were sold one year after the exercise and more than two years after the contract was granted. Therefore, the holder will not be subject to any compensation income, and the capital gain will be treated as a long-term capital gain. This scenario represents the most tax efficient outcome.

Example of a Disqualifying Disposition (Sale)

Summary:

• Incentive Stock Options (ISOs) have only one taxable event: at the point of exercise
• ISOs are different from Non-qualified Stock Options (NSOs) in that they may be eligible for favorable tax treatment under certain criteria
• ISO gains may be taxed at the long-term capital gains rate (significantly lower than the ordinary income rate) if the stock sale meets the requirements of a "qualifying disposition"

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