Stock can be purchased at the strike price as soon as the option vests, which makes it available to be exercised. Strike prices are set at the time the options are granted. But the options often vest over time. The ISO allows you to purchase stock in the future at the locked-in strike price if the stock increases in value. This discount on the purchase price of the stock is called the “spread.”
Taxing ISOs
The income from ISOs is subject to regular income tax and alternative minimum tax (AMT). But it’s not taxed for Social Security and Medicare purposes. You’ll need the following information to figure out the tax treatment of an ISO:
The grant date: The date the ISO was granted.The strike price: The cost to purchase a share of stock.The exercise date: The date on which the option was exercised and shares were purchased.Selling price: The gross amount received from selling the stock.Selling date: The date on which the stock was sold.
How ISOs are taxed depends on how and when you dispose of the stock.
Qualifying Dispositions of Incentive Stock Options
A qualifying disposition for an ISO means that the stock acquired is disposed of over two years from the grant date and more than one year after the stock was transferred to the employee (often the exercise date). There is an additional qualifying criterion: The taxpayer must have been continuously employed by the employer granting the ISO from the grant date up to three months before the exercise date.
Tax Treatment for Incentive Stock Options
Exercising an ISO is treated as income solely to figure the alternative minimum tax (AMT), but it’s ignored when calculating regular federal income tax. The spread between the fair market value of the stock and the option’s strike price is considered income for AMT purposes. The fair market value is measured on the day when the stock first becomes transferable or when the employee’s right to the stock is no longer subject to the risk of forfeiture.
Qualifying Dispositions of Incentive Stock Options
A qualifying disposition for an ISO is taxed as a capital gain at long-term capital gains tax rates and on the difference between the selling price and the cost of the option.
Disqualifying Dispositions of Incentive Stock Options
A disqualifying or non-qualifying disposition of ISO shares is any disposition other than a qualifying disposition. Disqualifying ISO dispositions are taxed in two ways: as compensation income (subject to ordinary income rates) and as capital gain or loss (subject to the short-term or long-term capital gains rates). The amount of compensation income is determined as follows:
The compensation income is the spread between the stock’s fair market value when the option was exercised and the option’s strike price if the ISO is sold at a profit.Any profit above compensation income is capital gain.The entire amount is a capital loss, and there is no compensation income to report if the ISO shares are sold at a loss.
Withholding and Estimating Taxes
Those who sell ISO shares may have significant tax liabilities not covered by payroll withholding. Taxpayers should send in estimated tax payments to avoid having a balance due on their tax returns. Taxpayers may also want to increase the amount of withholding instead of making estimated payments.
Reporting Requirements
ISOs are reported on Form 1040. How they’re reported depends on the type of disposition. There are three possible tax reporting scenarios.
Reporting the Exercise of Incentive Stock Options and Shares Not Sold in the Same Year
AMT income is increased by the spread between the fair market value of the shares and the exercise price in this case. This amount can be found using data found on Form 3921 provided by your employer.
First, find the fair market value of the unsold shares (IRS Form 3921, box 4 multiplied by box 5).Then subtract the cost of those shares (Form 3921, box 3 multiplied by box 5).The result is the spread. This is reported on IRS Form 6251, line 2i.
Income is being recognized for AMT purposes, so there’s a different cost basis in the shares for AMT than the shares for regular income tax purposes. It’s a good idea to keep track of this AMT cost basis for future reference. For regular tax purposes, the cost basis of the ISO shares is the price paid. This is the exercise or strike price. For AMT purposes, the cost basis is the strike price plus the AMT adjustment. This is the amount reported on Form 6251, line 2i.
Reporting a Qualifying Disposition of ISO Shares
The gain should be reported on Schedule D and IRS Form 8949. The gross proceeds from the sale are required. This information is provided by the broker on Form 1099-B. The regular cost basis must also be reported. This figure is the exercise or strike price found on Form 3921. A separate Schedule D and Form 8949 should be completed to find the capital gain or loss for AMT purposes. Report gross proceeds from the sale and the AMT cost basis on the separate Schedule D form. This is the exercise price plus any prior AMT adjustment. IRS Form 6251 will have a negative adjustment on line 2k to reflect the difference in gain or loss between the regular and AMT gain calculations. Refer to the 2022 Instructions for Form 6251 for details.
Reporting a Disqualifying Disposition of ISO Shares
Compensation income is reported as wages on IRS Form 1040, line 1. Any capital gain or loss is reported on Schedule D and Form 8949. Your compensation income may already be included on Form W-2, the employer’s wage, and tax statement. If so, it should appear in the amount shown in box 1. Sometimes employers will provide a detailed analysis of this amount at the top portion of the W-2. Simply report wages from box 1 on line 1 of your Form 1040 if compensation income is included on the W-2. Calculate compensation income. Include this amount as wages on line 1 of Form 1040 in addition to the amounts from Form W-2 if the compensation income has not already been included on the W-2. Report the gross proceeds from the sale of ISO shares on Schedule D and IRS Form 8949. This figure appears on Form 1099-B, which you should have received from your broker. You’ll also show the cost basis for the shares. The cost basis will be the strike price found on Form 3921 plus any compensation income reported as wages for disqualifying dispositions of ISO shares. The cost basis will be different if you sold ISO shares in a year other than the ISO exercised year. Complete a separate Schedule D and Form 8949 to report the different AMT gain. Use Form 6251 to report a negative adjustment for the difference between the AMT gain and the regular capital gain.
IRS Form 3921
IRS Form 3921 is used to provide employees with information relating to incentive stock options that were exercised during the year. Employers will provide the employee with one copy of this document for each exercise of ISOs during the calendar year. You may receive multiple 3921 documents or a consolidated statement showing all your exercises if you had two or more exercises. The formatting of this tax document may vary. But it will contain the following information:
Identity of the company transferring stock under the ISOEmployee’s identity who exercised the ISOThe date the incentive stock option was grantedThe date the incentive stock option was exercisedThe exercise price per shareThe fair market value per share on the exercise dateThe number of shares acquired
This information is used to arrive at the cost basis for the shares, the amount of income that needs to be reported for the alternative minimum tax, the amount of compensation income on a disqualifying disposition, and to identify the beginning and end of the special holding period to qualify for preferred tax treatment.
Identifying the Qualifying Holding Period
ISOs have a special holding period to qualify for capital gains tax treatment. The holding period is two years from the grant date and one year after the stock was transferred to the employee. IRS Form 3921 shows the grant date in box 1. It shows the transfer date or exercise date in box 2. Add two years to the date in box 1, and add one year to the date in box 2. It’s a qualifying disposition if the ISO shares are sold after the later date. Any profit or loss will be a capital gain or loss taxed at the long-term capital gains rates. It’s a disqualifying disposition if the ISO shares are sold at any time before or on this date. The income from the sale is taxed partly as compensation income at the ordinary income tax rates and partly as capital gain or loss.
Calculating Income for the AMT
Report additional income for the AMT if an ISO is exercised and the shares are not sold before the end of the calendar year. The amount included for AMT purposes is the difference between the fair market value of the stock and the cost of the incentive stock option on form 3921.
Fair market value per share appears in box 4.Per-share cost of the ISO (its exercise price) is in box 3.The number of shares purchased is in box 5.
Multiply the amount in box 4 by the number of unsold shares to find the amount to include as income for AMT purposes. It’s often the same as what’s reported in box 5. Subtract the exercise price from this product from box 3 multiplied by the number of unsold shares. This is often the same amount that’s shown in box 5. Report this amount on Form 6251, line 2i.
Calculating the Cost Basis for Regular Tax
The cost basis of shares acquired through an incentive stock option is the exercise price, shown in box 3. The cost basis for an entire lot of shares is the amount in box 3 multiplied by the number of shares shown in box 5. This figure will be used on Schedule D and Form 8949.
Calculating the Cost Basis for AMT
Shares exercised in one year and sold in a subsequent year have two cost bases: one for regular tax purposes and one for AMT purposes. The AMT cost basis is the regular tax basis plus the AMT income inclusion amount. This figure will be used on a separate Schedule D and Form 8949 for AMT calculations.
Calculating Compensation Income on a Disqualifying Disposition
When you exercise a stock option, the gains might be taxed as wages subject to ordinary income taxes. However, it’s possible you might pay income taxes and a capital gains tax after exercising an option and selling the shares. If you exercise an option before the holding period ends and eventually sell the stock, it’s considered a disqualifying disposition. You would need to pay ordinary income taxes on the gain from the difference between the fair market value of the stock—at the time you exercised—and the strike price of the option. If, after exercising, you sold the shares during the disqualifying holding period, but the stock price had risen even further, the remaining gain would be taxed as capital gains.
Example
Let’s say your employer granted you an ISO on March 12, 2020, to buy 100 shares of the company’s stock at $10 per share, which was the stock’s fair market value at that time.
You exercised the option on Jan. 10, 2021, when the stock’s market price was $12 per share.On Jan. 25, 2022, you sold the stock for $15 per share.Although the stock was held for more than a year, less than two years had passed since you were granted the option.
In 2022, you must report the difference between the option’s strike price ($10) and the stock’s market value when you exercised the option ($12) as ordinary income or wages. The remaining gain is taxed as a capital gain, as shown below:
Purchase price = $1,000 or ($10 strike price × 100 shares)Amount reported as ordinary income = $200 or ($12 market price at exercise - $10 strike price) × 100 sharesGain from selling the shares = $300 or ($15 market selling price -$12 strike price) × 100 sharesTotal gain = $500Reported as ordinary income = $200Reported as a capital gain = $300
Calculating the Adjusted Cost Basis of a Disqualifying Disposition
Start with the cost basis. Add any amount of compensation. Use this adjusted-cost-basis figure to report a capital gain or loss on Schedule D and Form 8949. The options are exercised. The employee buys the shares at the strike price and is free to sell them at the full market price or keep them in their portfolio as a long-term investment when the vesting period ends.
