The option must be for the purchase of stock of the employer or a related corporation. The option must be granted under a formal plan which may be in written or electronic form that is approved by shareholders of the granting corporation within 12 months before or after the date the plan is adopted by the corporation.
The plan under which the ISO is granted must include:. The option must be granted within ten years from the earlier of:. The exercise price of the option must not be less than:. The option holder must be an employee of the corporation granting the option or a related corporation at all times during the period beginning on the grant date and ending on the date that is three months before the date of exercise.
This means that, except in the case of the employee's termination due to death or permanent and total disability, if the option holder's employment terminates, the option holder must exercise the option no later than three months after the employee's termination date. If the employee's employment terminates due to permanent and total disability, the option must be exercised no later than one year after the employee's termination date. If the employee's employment terminates due to death, the option holder's heirs can exercise the option until the option's expiration date.
The tax paid is not a taxable gift to the donee, as it is a personal liability of the donor. The issuing company's plan must allow for gifting of such options. ISOs are similar to NQSOs in that they represent a right to purchase shares at a specific price within a certain period. For the option holder to reap these benefits, the options must qualify as ISOs under Sec. The following list illustrates some of the requirements that must be met for an option to be an ISO:. This list is not all - inclusive , but it provides a general idea of the types of rules that must be complied with for an option to qualify as an ISO.
Qualifying disposition: If options that meet the requirements to be ISOs are disposed of in a qualifying disposition, the owner of the ISOs will receive the following tax treatment upon exercise of the options and the subsequent sale of the stock:. Disqualifying disposition: If the ISO stock is disposed of in a disqualifying disposition i. Thus, the income attributable to the exercise of the option the FMV of the stock at the time it is substantially vested less the exercise price is treated by the option holder as ordinary compensation income for regular tax purposes in the tax year the disqualifying disposition occurs.
However, if the disqualifying disposition of the stock is a sale or exchange for a price less than the price of the stock at exercise, the amount that is includible as compensation attributable to the exercise of the option is limited to the excess if any of the amount realized on the sale or exchange over the adjusted basis of the stock.
Incentive Stock Options Checklist
If the disqualifying disposition occurs in the same year as the exercise, the tax treatment is similar to that for an NQSO, with the bargain element in the stock at the time of exercise being ordinary income for the option holder in the year of exercise for both regular tax and AMT purposes, so that no AMT adjustment is necessary in that year. If the stock is disposed of in a disqualifying disposition for an amount greater than the FMV of the stock at exercise, the character of the amount of gain is determined under the Sec. AMT considerations and planning opportunities.
Between the limitation and removal of typical itemized deductions that have caused taxpayers to be subject to the AMT, plus an increase in the AMT exemption amount, an environment has been created where many individuals who have historically been subject to the AMT will no longer find themselves in that situation. Individuals with high ordinary income, such as wages, could be even further immunized from the AMT regime.
On the surface, a taxpayer's being subject to the AMT in the year of exercise seemingly thwarts the strategy behind owning ISOs. This situation somewhat hinders the option holder's enjoyment of the coveted ISO benefits. It is important to remember that all is not necessarily lost if clients find themselves subject to the AMT during the year of exercise due to the AMT credit, which is explored further below. The following are some planning options associated with ISOs:. Exercising and immediately selling will trigger a disqualifying disposition.
Similar to the strategy discussed in the NQSO section, this strategy may appeal to those clients looking to limit their cash outlay or exposure to a concentrated position in company stock. The options are exercised and the shares are sold more than two years after the grant date and more than one year after exercise. The tax results of a qualifying disposition are described above.
Non-Qualified Stock Options Taxation
As noted, in this scenario, appreciation in the value of the stock above the exercise price will be taxed at long - term capital gains rates. Intentional disqualifyingdisposition. Prior to the dot - com bubble of the late s, many individuals in the tech industry exercised highly valued ISOs, incurring a large AMT liability on top of the price paid to exercise options. After the market crash and subsequent rapid devaluation of their position, some were left holding stock worth significantly less than the price they paid to acquire it and were unable to pay the AMT incurred due to the exercise of the ISOs.
A method to potentially avoid a disaster like this would be to exercise early in the year, or some other time that is deemed advantageous, and track the stock value throughout the year. If the value greatly depreciates, the stock can be sold before year end. This would intentionally trigger a disqualifying disposition, thus avoiding the positive AMT adjustment and any accompanying AMT tax liability. This is a mix of the exercise - and - sell and the exercise - and - hold strategies.
Incentive and Non-Qualified Options Are Taxed Differently
Like the strategy discussed in the NQSO planning section, this can be used to improve cash flow during the exercise event. The immediate sale of the shares to cover the AMT is a disqualifying disposition. The remaining shares received can be held for future appreciation and, if the holding period requirements are met, favorable qualifying disposition treatment.
If an individual already owns shares of company stock and wants to limit the cash outlay on the exercise of ISOs, a swap could be of value. The existing shares will be exchanged with the issuing company for the new ISO shares. It is important to note that the swap itself is tax - free , but not necessarily the exercise, as this could generate an AMT liability.
Consideration should be given for special situations, such as if the shares being swapped in are ISO shares themselves. The company's stock plan must allow for swapping. When taxpayers find themselves subject to the AMT as a result of the exercise of ISOs, all or part of the AMT paid will generate a credit to be used against regular tax in future years. Often, the principal event that will unlock use of this credit is when the ISO shares are ultimately sold.
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The regular tax stock basis is lower due to the absence of any income inclusion at exercise. This difference in basis for regular tax versus AMT purposes generally causes the regular - tax income to be higher than AMTI as a result of the sale. While paying AMT upfront may appear to be a loss, in many cases it will be a "timing" issue that balances out in the future.
At times for CPAs, it is easy to focus narrowly on obtaining the best tax result possible. It is important to take a step back and remember that the most favorable tax result is not always the best overall financial result for the client.
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Capital Gains From Sale After Holding When you sell the shares acquired at exercise, you are taxed on your capital gains, as with any stock you purchase. You sell the shares more than one year later. Print this answer:. Share this answer:. We've updated our Privacy Policy, and this site uses cookies. Read the Privacy Policy to learn more. Got it.