ISO Actions That Generate Taxable Events

• For regular income tax purposes, no income tax is due when the options are granted or when they are exercised. Instead, the tax is deferred until the stock is sold, at which time the entire gain is taxed.
• Furthermore, the character of the income (ordinary versus capital gain) from the sale of the ISO stock depends on whether the sale is considered a qualifying disposition or disqualifying disposition.
  
  

Tax Consequences of a Qualifying Disposition

• The difference between sales price and exercise price, or spread, is taxed as a long-term capital gain.
  
  

Tax Consequences of a Disqualifying Disposition

• The spread is taxed as ordinary income.
• Additionally, tax will be due on any increase in value between the exercise date and the sale date. The tax rate will depend on whether a short-term capital gain or long-term capital gain is realized.
  
  

Positive Alternative Minimum Tax (AMT) Adjustment Upon Exercise

• The exercise of an ISO is considered a preference income item under AMT. Therefore, AMT income is increased by the spread.
• The positive AMT adjustment creates phantom income, which can significantly (and unexpectedly) increase one’s tax liability.
  
  

Negative AMT Adjustment Upon Sale

• Generally, the sale of ISO stock will create a negative AMT adjustment equal to the excess of the AMT stock basis over the regular tax stock basis in the year of sale.
• If the stock is sold in the year the ISO is exercised, a disqualifying disposition occurs and no AMT adjustment is required.
  
  

Minimum Tax Credit (MTC)

• The minimum tax credit is created by the AMT liability generated as a result of exercising ISOs. This tax credit offsets regular tax liability in future years to prevent double taxation.
  
  

Dual Tracking of Basis

• The basis of ISO stock must be tracked for the purpose of calculating gain or loss upon sale or exchange for both the regular tax and AMT.
  • Regular basis equals the amount paid for the shares (the exercise price).
  • AMT basis equals the amount paid for the stock plus the positive AMT adjustment (the spread). This also equals the fair market value at the date of exercise.
    
    

No Payroll Taxes Due on ISOs

• No payroll taxes are due, even when there is a disqualifying disposition.
• Even though these transactions are exempt from federal and state income tax withholding, they may still be taxable. Estimated tax payments may be necessary.
  
  

Tax Planning Consideration – Develop an Exercise/Sale Schedule!

Key Terms & Definitions

Alternative Minimum Tax (AMT) – A separate tax that applies in addition to regular tax. AMT applies to taxpayers who have certain types of income that receive favorable treatment or who qualify for certain deductions under the tax law. These tax benefits can significantly reduce the regular tax of some taxpayers with higher incomes. AMT helps to ensure that those taxpayers pay at least a minimum amount of tax.

Disqualifying Disposition – A sale of ISO stock that fails to meet the holding period or employment requirements of a qualifying disposition (defined below).

Exercise Date – The date on which an employee exercises an option to purchase employer stock.

Exercise Price (Grant Price; Strike Price) – The amount an employee must pay to purchase the stock under the terms of the option agreement.

Expiration Date – The date an option expires if it is not exercised.


Grant Date – The date the company grants an employee an option to purchase employer stock.

Holding Period – The period beginning the day after an asset is acquired (the day after the exercise date) and ending the day the asset is sold.

Incentive Stock Option (ISO) – Statutory option that is given preferential tax treatment for meeting certain IRS qualifications.

Long-Term Capital Gain (LTCG) – A gain resulting from the sale of an asset held for more than one year that is taxed at the taxpayer’s preferred tax rate, ranging from 0% to 20%.

Minimum Tax Credit (MTC) – Credit created by the AMT liability generated as a result of a deferral or preference item (such as exercising ISOs). The credit can offset regular tax in future years to the extent regular tax exceeds AMT.

Ordinary Income (OI) – Includes all types of income with the exception of long-term capital gains and qualified dividends. The tax rate on ordinary income ranges from 10% to 37%.

Qualifying Disposition – A sale of ISO stock that meets the following requirements: (1) the employee does not sell/dispose of the employer stock within two years of the grant date; (2) the employee does not sell/dispose of the employer stock within one year of the exercise date; and (3) the individual was continuously employed by the corporation granting the ISO from the grant date of the ISO up to three months before the exercise date.

Regular Tax – The total tax paid by taxpayers not subject to AMT (defined above). All preferential income items and deductions are allowed.

Short-Term Capital Gain (STCG) – A gain resulting from the sale of an asset held for one year or less that is taxed at the taxpayer’s ordinary income tax rate, ranging from 10% to 37%.

Spread – The difference between the exercise price and the fair market value (FMV) of the stock at the exercise date.

Vesting Date – The date an employee is first eligible to exercise an option.