Tax Prep & Planning

Learn About Incentive Stock Options & How They Are Taxed

As an employee, one benefit you may receive is incentive stock options. Learn what they are and how they are taxed in this post.

What Are Incentive Stock Options?

Incentive stock options (ISOs) are a type of employee compensation in the form of stock.

Why Do Employers Give ISOs?

Employers may offer ISOs as an incentive to potential recruits or as a benefit to employees. With an ISO, an employer gives an employee the option to purchase stock in the employer’s corporation at a predetermined price, called the exercise or “strike” price.

The employee may exercise the option, that is, purchase the stock at the strike price as soon as the option is vested, meaning a set amount of time has elapsed after which the employee can take action (usually one year). Generally, employees exercise options when the stock has increased in value.

The difference between the strike price and the fair market value (FMV) at the time of the exercise is called the discount or “spread.” The spread may be subject to regular income tax or alternative minimum tax (AMT), but is not taxed for Social Security and Medicare purposes.

So, sounds tricky, right? Well, read on and we’ll distill it for you.

How Are Incentive Stock Options Taxed?

If you exercised ISOs in this tax calendar year, you may have regular tax or AMT consequences. The tax treatment depends on whether you’ve continued to hold the stock through the end of the year or you have sold it.

To figure out the taxation of an ISO, you will need the following information:

  • Grant date: the date the ISO is granted to an employee
  • Strike price: the cost of a share of stock
  • Exercise date: the purchase date of the ISO shares
  • FMV: the value of the stock when it is exercised
  • Sales price: the gross amount received from selling the ISO
  • Sales date: the date the stock is sold

Taxes on Incentive Stock Options

If you do not sell the ISO stock in the year you exercise the option, you do not have any regular tax consequence but you do have taxable income for AMT purposes.

The income subject to AMT is the difference between the fair market value (FMV) of the stock and the options’ strike prices times the number of shares exercised. For instance, if you exercised 500 ISOs at a strike price of $10 when the FMV of the stock was $25 per share, the income subject to AMT is $7,500 [($25-$10) × 500]

Tax Treatment for Qualifying Dispositions and Disqualifying Dispositions of Incentive Stock Options

A qualifying disposition of an ISO means that you have held the option at least one year after the exercise date and at least two years after the grant date. If the holding periods are met, the difference between the selling price and the strike price is taxed at favorable long-term capital gain rates.

Since you paid AMT (but not regular tax) when you exercised the option, your AMT basis in the stock is different from your regular basis. Your AMT basis includes the strike price plus the spread that was previously taxed for AMT. Thus, your capital gain for AMT purposes will be less than your capital gain for regular tax purposes.

Continuing with the above example, when the stock is later sold in a qualifying disposition, the per share basis for regular tax purposes is $10 per share but the per share basis for AMT purposes is $25 per share ($10 strike price + $15 spread).

If the holding periods are not met, for example, if you sell the stock immediately upon exercise, the spread between the strike price and FMV at the time of exercise is included as ordinary income in your compensation and reported on your Form W-2. There is no AMT consequence. Your basis in the stock is the strike price plus the additional compensation. Any difference between the FMV at the time of purchase and sales prices is short-term capital gain or loss. Many employees do a “cashless exercise” which means they sell the stock almost immediately after the exercise. In that case, the sales price and FMV will be very close and the capital gain or loss will be very small.

Withholding and Estimating Taxes

Be aware that employers are not required to withhold taxes on the exercise or sale of incentive stock options. Accordingly, those who have exercised but not yet sold ISO shares at the end of the year may have incurred AMT liabilities. Additionally, those who sell ISO shares may have significant tax liabilities not covered by payroll withholding. Taxpayers should make estimated tax payments to avoid having a balance due on their tax return. Taxpayers may also want to increase the amount of withholding instead of making estimated payments.

Here are more supporting tax forms you may use with ISOs:

Form 1040

ISOs are reported on Form 1040. You may have ordinary income, capital gain (or loss), or both.

Form W-2

Include any compensation income received from your employer shown on your W-2.

Form 1099-B

You receive this form the year you sell the stock units. It reports capital gain or loss on your tax return.

If your Form 1099-B is missing a cost basis amount, you must still calculate and report it on your return.

Form 3921 (Exercise of Incentive Stock Options)

Your employer will provide this form for the year you exercise ISOs. Information on the form will help you determine AMT, if applicable.

Form 6251 (Alternative Minimum Tax)

You report AMT from the exercise of an ISO on this form

Insights Icon

Get Matched Today

Find Your Advisor