How Employer-Issued ISOs May Affect Your Taxes

22 January 2024

Employer stock options are a potentially valuable asset for recipient employees, especially those who work for start-ups or high-growth companies. For example, many Silicon Valley millionaires reaped sizable windfalls by exercising their employer stock options. Here's a summary of the federal income tax rules for incentive stock options (ISOs).

Tax Planning Objectives

Stock options give you the right — but not the obligation — to buy company stock at a set price (the exercise price) before a specified expiration date. With ISOs, the exercise price must be equal to or greater than the stock's fair market value (FMV) at the date of the grant. So, ISOs don't provide a financial benefit unless the underlying stock appreciates in value. If it does, you can exercise the ISO to buy shares at a price below what they're then trading for, provided you're eligible to exercise.

If you exercise ISOs, and eventually sell the option shares for a profit, your two main tax planning objectives are:

1. To have most or all the profit taxed at lower long-term capital gains rates, and

2. To postpone paying taxes for as long as possible. 

However, you shouldn't allow these tax planning objectives to override the more fundamental financial planning objective of making as much money as possible on the deal without taking excessive risks.

Tax Implications  

ISOs are also known as qualified options or statutory options. They're entitled to preferential federal income tax treatment. They're also subject to tax-law restrictions that usually make them unattractive for high-level company executives. And exercising ISOs can trigger unfavorable alternative minimum tax (AMT) results.  

With ISOs, you must consider both the regular federal income tax results and the AMT results. In addition, you need to pay attention to special rules that apply to so-called disqualifying dispositions of shares acquired by exercising ISOs.

Federal Income Tax Details

When you exercise ISOs, the excess of market value over the exercise price (the so-called bargain element or spread) isn't taxed. In addition, when you sell the ISO shares, the entire profit (the difference between the sales price and the exercise price) can potentially qualify for favorable long-term capital gains treatment. However, for that treatment to apply to the entire profit, the date of sale must be:

• More than two years after the option grant date, and
• More than 12 months after you exercised the option.

If you satisfy these timing rules, the profit will be taxed at favorable long-term capital gains rates. Plus, the tax bill will be delayed until you sell the option shares. So, you'll have cash on hand to pay your federal income tax bill (and any state income tax bill, if applicable).

AMT Treatment

With ISO shares, the bargain element on the exercise date counts as an adjustment for AMT purposes. The adjustment will increase your AMT income in the year of exercise. This could potentially cause the AMT to exceed your regular federal income tax bill if the adjustment is big because your ISO exercise was highly profitable. If that happens, you must pay the higher AMT amount. Thankfully, the Tax Cuts and Jobs Act greatly reduced the odds of owing the AMT, through 2025. Check with your tax advisor about your possible exposure to the AMT. 

If you wind up owing AMT in the year of exercise, you may be entitled to an AMT credit. This can be used to reduce your regular federal income tax bill in a later year.

When you sell ISO shares, the resulting gain or loss must be calculated under the AMT rules. The AMT basis equals the FMV on the exercise date (not the lower exercise price, which is the regular tax basis). The higher AMT basis shows up as a negative adjustment for the year of sale.

If you sell the share for more than FMV on the exercise date, you'll have a gain for both AMT and regular tax. But the AMT gain will be lower.

If you sell for less than FMV on the exercise date but more than the exercise price, you'll have an AMT loss and a regular tax gain. In either case, if you earned an AMT credit for the year of exercise and you haven't yet used it, you can probably use the credit in the year of sale.

Regular Results from Disqualifying Dispositions

Timing is critical when selling ISOs. When you sell ISO shares within two years of the grant date or within one year of the exercise date, the sale is considered a "disqualifying disposition."

When the sale price exceeds the exercise price, you have a regular income tax gain from a disqualifying disposition. The gain up to the amount of the bargain element (the spread between market value and exercise price on the exercise date) is considered ordinary income in the year of sale. That piece gets taxed at your regular federal income tax rate, which can be as high as 37%. Any additional profit is considered a capital gain and is subject to the normal tax rules for capital gains. 

When the per-share sale price is less than the per-share FMV on the exercise date, the ordinary income piece is limited to the amount of gain on the sale.

The tax rate on the capital gain (the amount of gain in excess of the bargain element) depends on how long you owned the shares. Your ownership period is deemed to start on the day after the exercise date. For example, if you have a disqualifying disposition because the sale date is less than two years after the grant date but more than a year after the exercise date, the capital gain piece is taxed at long-term capital gains rates. If you hold ISO shares until they fall below the exercise price, you'll have a regular tax capital loss on a disqualifying disposition.

Important: You can also get hit with the 3.8% net investment income tax on all or part of the gain from selling ISO shares.

AMT Results from Disqualifying Dispositions

If you exercise your ISO and then make a disqualifying disposition of option shares in the same year, there are no AMT consequences. However, if the exercise and disqualifying disposition occur in different years, the positive adjustment for the bargain element may cause an AMT liability in the exercise year. In that case, you'll likely generate an AMT credit that you can use to reduce your regular tax bill for the later year when you sell option shares. 

NQSOs Are a Different Story

Some companies issue nonqualified stock options (NQSOs) to employees. These options aren't subject to any tax-law restrictions, but they also confer no special tax advantages. That said, you can get good tax results with advance planning. Employer-issued stock options that aren't ISOs are NQSOs by default.

The tax rules that apply to employer-issued stock options are complicated. Before exercising or selling your options,  please reach out to a member of our Tax Team to determine what's right for your situation.

 

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