US Incentive Stock Options (ISO’s)

Incentive Stock Options (ISOs) help attract and retain employees. While ISOs can offer a valuable opportunity to participate in your company's growth and profits, there are tax implications.
What are Incentive Stock Options?
A stock option grants you the right to purchase a certain number of shares of stock at an established price. There are two types of stock options—
1. Incentive Stock Options (ISOs)  and
2. Non-qualified Stock Options (NSOs)

They are treated very differently for tax purposes. In most cases, Incentive Stock Options provide more favorable tax treatment than Non-qualified Stock Options.

Why are Incentive Stock Options more favorable tax-wise?

When you exercise Incentive Stock Options, you buy the stock at a pre-established price, which could be well below actual market value. The advantage of an ISO is you do not have to report income when you receive a stock option grant or when you exercise that option. You report the taxable income only when you sell the stock. And, depending on how long you own the stock, that income could be taxed at capital gain rates—typically a lot lower than your ordinary income tax rate. With ISOs, your taxes depend on the dates of the transactions (that is, when you exercise the options to buy the stock and when you sell the stock). The price break between the grant price you pay and the fair market value on the day you exercise the options to buy the stock is known as the bargain element. There is a catch with Incentive Stock Options, however: you do have to report that bargain element as taxable compensation for Alternative Minimum Tax (AMT) purposes in the year you exercise the options (unless you sell the stock in the same year).

With Non-qualified Stock Options, you must report the price break as taxable compensation in the year you exercise your options, and it's taxed at your regular income tax rate

How transactions affect your taxes
Incentive Stock Option transactions fall into five possible categories, each of which may get taxed a little differently.
With an ISO, you can:
1. Exercise your option to purchase the shares and hold them.
2. Exercise your option to purchase the shares, then sell them any time within the same year.
3. Exercise your option to purchase the shares and sell them after less than 12 months, but during the following calendar year.
4. Sell shares at least one year and a day after you purchased them, but less than two years since your original grant date.
5. Sell shares at least one year and a day after you purchased them, and at least two years since the original grant date.

Each transaction has different tax implications. The first and last are the most favorable. The time at which you sell determines how the proceeds are taxed.

Quick Summary

If you can wait at least a year and a day after you purchase the stocks, and at least two years after you were granted the option to sell the stocks (as described in item 5 above), any profit on the sale is treated as a long-term capital gain, so it is taxed at a lower rate than your regular income. (Your profit is the difference between the bargain price you pay for the stock, and the market price that you sell it for.)

Sales that meet these one- and two-year time limits are called "qualifying dispositions," because they qualify for favorable tax treatment.
No compensation is reported to you on your Form W-2, so you do not have to pay taxes on the transaction as ordinary income at your regular tax rate.

Now, if you sell the shares before they meet the criteria for favorable capital gains treatment, the sales are considered "disqualifying dispositions," and you may end up paying taxes on part of the proceeds of the sale at your ordinary income tax rate

When you sell the stock two years or less from the offering date, known as the "grant date," the transaction is a disqualifying disposition.
Or if you sell the shares one year or less from the "exercise date," which is when you purchase the stock, that is also considered a disqualifying disposition.
In both cases, the compensation should be reported on your Form W-2.

The amount reported on your Form W-2 is the bargain element, which is the difference between what you paid for the stock and its fair market value on the day you bought it. But if your bargain element is more than your actual gain from the sale of the stock, then you report as compensation the amount of the actual gain. The reported compensation is taxed as ordinary income.

1. Exercise your option to purchase the shares and hold them. You do not report anything on your 2020 Schedule D (Capital Gains and Losses) because you have not yet sold the stock. Your employer will not include any compensation related to your options on your 2020 Form W-2 either. You will have to make an adjustment for the Alternative Minimum Tax (AMT) that equals the bargain element

2. Exercise your option to purchase the shares, and then sell those shares within the same calendar year. The bargain element is the difference between the exercise price and the market price on the day you exercised the options and purchased the stock. This amount should already be included in the total wages reported in Box 1 of your 2020 Form W-2 because this is a "disqualifying sale." This means you are disqualified from taking it as a capital gain and being taxed at the lower capital gains rate because you sold the shares less than a year after exercising the option.  If this amount is not included in Box 1 of Form W-2, add it as "Other Income" on your Form 1040. Report the sale on your 2020 Schedule D, Part I as a short-term sale. The sale is short-term because not more than one year passed between the date you acquired the actual stock and the date you sold it.

3. Sell shares in the next calendar year, but less than 12 months after you purchased them. A wash sale: if you repurchase shares in the same company (such as through an employee stock purchase plan) within 30 days before or after the sale of the shares obtained from the exercise of the option, some or all of the sale will be considered a wash sale. You will not be allowed to report the lesser calculation as income for shares sold in a wash sale. You must report the full $2,500 as income. A sale to a related party: If you sell the shares to a related party (a member of your family, or a partnership or corporation in which you have more than a 50 percent interest), you must report the full $2,500 as income.

A gift: If you gave the stock to an individual or a charity, rather than selling the shares, you must report the full $2,500 as income.
Report the sale on your 2020 Schedule D, Part I, as a short-term sale. It's considered short-term because less than one year passed between the date you acquired the stock and the date you sold it. Because this sale did not occur in the same year as the year you exercised the options, you have to make an adjustment for AMT.  When you originally purchased the stock, you should have reported an income adjustment for AMT purposes in that year.
Find out if this was the case by looking at Form 6251 (Alternative Minimum Tax) for the year that you purchased the shares.

4. Sell shares at least one year and a day after you purchase, but less than two years after the grant date. You also must report the sale of the stock on your 2020 Schedule D, Part II as a long-term sale. It is long term because more than one year passed between the date you acquired the stock and the date you sold it. Because this sale did not occur in the same year as the year you exercised the options, you have to make an adjustment for AMT. When you originally purchased the stock, you should have reported an income adjustment for AMT purposes in that year.
Find out if this was the case by looking at Form 6251 (Alternative Minimum Tax) for the year that you purchased the shares. So what do you do this year? You will have to report another adjustment on your 2020 Form 6251. We explain how you calculate your AMT adjustment in the section called Reporting an Incentive Stock Option Adjustment for the Alternative Minimum Tax below.

5. Sell shares at least one year and a day after you purchase and at least two years after the grant date

This sale is a qualifying sale, because:
a. more than two years passed between the grant date and the sale date,  and
b. more than one year passed between the exercise date and the sales date. Because this is a qualifying sale, the 2020 Form W-2 you receive from your employer will not report any compensation amount for this sale. Report the sale on your 2020 Schedule D, Part II as a long-term sale. It is long-term because more than one year passed between the date you acquired the stock and the date you sold it. Because this sale and the exercise of the options didn't occur in the same year, you must make an adjustment for AMT. When you originally purchased the stock, you should have reported an income adjustment for AMT purposes in that year.
Find out if this was the case by looking at Form 6251 (Alternative Minimum Tax) for the year that you purchased the shares.
Reporting an Incentive Stock Option adjustment for the Alternative Minimum Tax
If you buy and hold, you will report the bargain element as income for Alternative Minimum Tax purposes.
Report this amount on Form 6251: Alternative Minimum Tax for the year you exercise the ISOs.
When you sell the stock in a later year, you must report another adjustment on your Form 6251 for the year of sale.
But what is the adjustment you should report? The year-of-sale Form 6251 adjustment is added to the stock's cost basis for Alternative Minimum Tax purposes (but not for regular tax purposes).
Unused AMT credits
In the year that you exercise an Incentive Stock Option, the difference between the market value of the stock on the exercise date and the exercise price counts as income under the AMT rules, which can trigger an AMT liability.
Consider the entire picture
It's important to take a look at the whole picture of your capital gains and losses for AMT purposes when you sell stock that you purchased by exercising Incentive Stock Options. If the market turns on you after you have exercised your options and the current value of your stock is now less than what you paid, you could still be subject to the Alternative Minimum Tax.
One way around that is to sell the stock in the same year that you bought it, creating a "disqualifying" disposition. That way you will not be subject to the AMT, but you would be subject to regular tax on the difference between your option exercise price and the sales price.

Be sure to plan for the tax consequences when you consider the consequences of selling the stock.

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