ISO Stock Options Compensation Income Vs. Capital Gains

There are five ways to time the sale of ISO shares.

By choosing wisely, an employee who exercises an incentive stock option (ISO) may delay any income tax consequences plus benefit from the reduced tax rate on capital gains. The tax characteristics that distinguish an ISO from ordinary stock options are lost by disqualifying actions of an employee. There are five possible ways for an employee to address an ISO.

Exercise and Hold

When an ISO is exercised, there is no tax consequence if the stock is held and not immediately sold. Nothing is added as compensation on the employee's W-2. This strategy defers any income tax. The employee is expecting a gain in the future from appreciation of the stock price. No "bargain element" is added to compensation. The bargain element consists of the difference between exercise price and market price on the date of exercise.

Sell on the Date of Exercise

Selling the stock on the same date as exercise of the ISO results in addition of the bargain element as compensation on the employee's W-2. The sale is still reported as a short-term capital gain. However, the amount of gain is zero because the basis equals the sale proceeds---with possibly a small loss for any sale commission. The basis is the stock exercise price plus the bargain element already added to compensation.

Sell Within One Year of Exercise

When stock obtained from exercising an ISO is sold within one year after exercise, the bargain element is taxed as compensation. If the bargain element has not been reported on a W-2, the employee must add it with other compensation on his income tax return.

Any excess of the sale proceeds over the basis is taxed as a short-term capital gain. The basis in the stock is the exercise price plus the bargain element.

If the sale proceeds are less than the stock's market value on the exercise date, only the net gain is taxed as compensation. The basis is therefore the exercise price plus the gain. The resulting capital gain is zero. All of the gain is already taxed as compensation.

Sell One Year After Exercise

The sale of stock more than one year after exercise creates a long-term capital gain. This gain is the excess of sale proceeds over the basis. Unless the sale is a qualifying sale, the bargain element must be taxed as ordinary compensation. The basis will then consist of the exercise price plus the bargain element.

Qualifying Sale

To qualify for special tax treatment, stock acquired from exercise of an ISO must be sold more than one year after exercise and more than two years after the options were granted. In this case, the sale is a long-term capital gain. The basis will only be the exercise price. The bargain element is not taxed as ordinary compensation.
However, even if qualifying sale requirements are met, when the option exercise price is below the stock's market value on the option grant date, this discount is still taxed as ordinary compensation.

References

• Internal Revenue Service: Publication 525
• Internal Revenue Service: Publication 551