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Incentive Stock Options Tax treatment of incentive stock options (ISO) By William Perez, About.com Guide

Aug 30 2011
Incentive stock options are a form of compensation to employees in the form of stock rather than cash. With an incentive stock option (ISO), the employer grants to the employee an option to purchase stock in the employer's corporation, or parent or subsidiary corporations, at a predetermined price, called the exercise price or strike price. Stock can be purchased at the strike price as soon as the option vests (becomes available to be exercised). Strike prices are set at the time the options are granted, but the options usually vest over a period of time. If the stock increases in value, an ISO provides employees with the ability to purchase stock in the future at the previously locked-in strike price. This discount in the purchase price of the stock is called the spread. ISOs are taxed in two ways: on the spread and on any increase (or decrease) in the stock's value when sold or otherwise disposed. Income from ISOs are taxed for regular income tax and alternative minimum tax, but are not taxed for Social Security and Medicare purposes.

In order to calculate the tax treatment of ISOs, you'll need to know:

Grant date: the date the ISOs were granted to the employee
Strike price: the cost to purchase a share of stock
Exercise date: the date on which you exercised your option and purchased shares
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 the stock is disposed. Disposition of stock is typically when the employee sells the stock, but it can also include transferring the stock to another person or giving the stock to charity.

Qualifying dispositions of incentive stock options
A qualifying disposition of ISOs simply means that the stock, which was acquired through an incentive stock option, was disposed more than two years from the grant date and more than one year after the stock was transferred to the employee (usually the exercise date). There's an additional qualifying criteria: the taxpayer must have been continuously employed by the employer granting the ISO from the grant date up to 3 months prior to the exercise date.

Tax treatment of exercising incentive stock options
Exercising an ISO is treated as income solely for the purpose of calculating the alternative minimum tax (AMT), but is ignored for the purpose of calculating the regular federal income tax. The spread between the fair market value of the stock and the option's strike price is included as income for AMT purposes. The fair market value is measured on the date when the stock first becomes transferable or when your right to the stock is no longer subject to a substantial risk of forfeiture. This inclusion of the ISO spread in AMT income is triggered only if you continue to hold the stock at the end of the same year in which you exercised the option. If the stock is sold within the same year as exercise, then the spread does not need to be included in your AMT income.

Tax treatment of a qualifying dispositions of incentive stock options
A qualifying disposition of an ISO is taxed as a capital gain at the long-term capital gains tax rates on the difference between the selling price and the cost of the option.

Tax treatment of disqualifying dispositions of incentive stock options
A disqualifying or nonqualifying disposition of ISO shares is any disposition other than a qualifying disposition. Disqualifying ISO dispositions are taxed in two ways: there will be compensation income (subject to ordinary income rates) and capital gain or loss (subject to the short-term or long-term capital gains rates).

The amount of compensation income is determined as follows:

if you sell the ISO at a profit, then your compensation income is the spread between the stock's fair market value when you exercised the option and the option's strike price.
Any profit above compensation income is capital gain.
If you sell the ISO shares at a loss, the entire amount is a capital loss and there's no compensation income to report.

Withholding and Estimated Taxes
Be aware that employers are not required to withhold taxes on the exercise or sale of incentive stock options. Accordingly, persons who have exercised but not yet sold ISO shares at the end of the year may have incurred alternative minimum tax liabilities. And persons who sell ISO shares may have significant tax liabilities that aren't paid for through payroll withholding. Taxpayers should send in payments of estimated tax to avoid having a balance due on their tax return. You may also want to increase the amount of withholding in lieu of making estimated payments.


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