The options do not convey an ownership interest, but exercising them to acquire the stock does.
There are different types of options, each with their own tax results. Stock options fall into two categories:. The grant of an ISO or other statutory stock option does not produce any immediate income subject to regular income taxes. Similarly, the exercise of the option to obtain the stock does not produce any immediate income as long as you hold the stock in the year you acquire it.
Income results when you later sell the stock acquired by exercising the option.
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The adjustment is the difference between the fair market value of the stock acquired through the exercise of the ISO over the amount paid for the stock, plus the amount paid for the ISO if any. However, the adjustment is required only if your rights in the stock are transferable and not subject to a substantial risk of forfeiture in the year the ISO is exercised. And the fair market value of the stock for purposes of the adjustment is determined without regard to any lapse restriction when rights in the stock first become transferable or when the rights are no longer subject to a substantial risk of forfeiture.
This is because the tax treatment becomes the same for regular tax and AMT purposes. When you exercise an ISO, your employer issues Form —Exercise of an Incentive Stock Option Plan under Section b , which provides the information needed for tax-reporting purposes.
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For example, this year you exercised an ISO to acquire shares of stock, the rights of which became immediately transferable and not subject to a substantial risk of forfeiture. The number of shares acquired is listed in box 5.
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When you sell the stock acquired through the exercise of an ISO or an employee stock purchase plan, you report a gain or loss on the sale. The information on this form helps you determine the amount of gain or loss, and whether it is capital or ordinary income.
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For this type of stock option, there are three events, each with their own tax results: The grant of the option, the exercise of the option, and the sale of stock acquired through the exercise of the option. The receipt of these options is immediately taxable only if their fair market value can be readily determined e. When you exercise the option, you include, in income, the fair market value of the stock at the time you acquired it, less any amount you paid for the stock.
This is ordinary wage income reported on your W2, therefore increasing your tax basis in the stock. Later, when you sell the stock acquired through exercise of the options, you report a capital gain or loss for the difference between your tax basis and what you receive on the sale. Stock options can be a valuable employee benefit. However, the tax rules are complex. ISOs may be issued both by public companies and private companies, with ISOs being common as a form of executive compensation for public companies, and common as a form of equity compensation in private start-up companies.
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Rather, if the shares are held for 1 year from the date of exercise and 2 years from the date of grant a "qualifying disposition" , then the profit made above the strike price is taxed entirely as a long-term capital gain, at a maximum rate of Tax treatment for the incentive stock option was created by the Revenue Act of The introduction of restricted shares and performance shares in the s and s diminished its popularity, but stock options continued to dominate through the s, s, and s. In October , section a of the tax code was added by the American Jobs Creation Act of , which set rules requiring the strike price of the option grant to be at least the fair market value, giving rise to the term a valuation.
In , law professor Erik Lie published a report into the options backdating involving changing the strike price and date of an option after issue, which led to over SEC and DOJ investigations, resulting in 12 criminal sentences. As of , stock options including ISOs are no longer the most common form of long-term equity incentive rewards for executives, with about half given as performance shares, a quarter as RSUs , and a quarter as stock options.
If the shares are sold before this required holding period a "disqualifying disposition" in the same tax year, then the difference between the price at the time of exercise minus the strike price is taxed as ordinary income, and any additional gain on top of the exercise price is taxed as a short-term capital gain.
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Short-term capital gains are subject to the same tax brackets as ordinary income but are also subject to the 3. If the incentive stock option is sold above the strike price but below the exercise price in the same tax year, the income is recognized solely as ordinary income. If sold before the required 1-year holding period in a different tax year. Even if a disqualifying disposition is made, if the shares exercised are not sold in the same tax year, the holder must calculate to see if any alternative minimum tax is owed. Although ISOs have more favorable tax treatment than NSOs non-qualified stock options or nonstatutory stock options , they require the holder to take on more risk by holding the stock for a longer period of time if the holder is to receive optimal tax treatment.
However, even if the holder disposes of the stock within a year, it is possible that there will still be marginal tax deferral value as compared to NQOs if the holding period, though less than a year, straddles the ending of the taxpayer's taxable reporting period. Ordinary income from incentive stock options, unlike wage income or income from NSOs, is also not subject to payroll taxes such as FICA. For more information, refer to the Instructions for Form You have taxable income or deductible loss when you sell the stock you bought by exercising the option.
You generally treat this amount as a capital gain or loss. However, if you don't meet special holding period requirements, you'll have to treat income from the sale as ordinary income. Add these amounts, which are treated as wages, to the basis of the stock in determining the gain or loss on the stock's disposition. Refer to Publication for specific details on the type of stock option, as well as rules for when income is reported and how income is reported for income tax purposes.
This form will report important dates and values needed to determine the correct amount of capital and ordinary income if applicable to be reported on your return. Employee Stock Purchase Plan - After your first transfer or sale of stock acquired by exercising an option granted under an employee stock purchase plan, you should receive from your employer a Form , Transfer of Stock Acquired Through an Employee Stock Purchase Plan under Section c.
This form will report important dates and values needed to determine the correct amount of capital and ordinary income to be reported on your return.