Incentive Stock Option Information
Incentive Stock Options (ISOs) have distinct tax characteristics that an employee may wish to retain or ignore. An employee enjoys a tax benefit from long-term holding of stock acquired from exercising ISOs. However, this is only a profitable endeavor when there is an appreciation in the stock's price. In addition, ISOs are subject to the Alternative Minimum Tax (AMT) system, even when no regular income tax is payable.
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Qualified Holding Period
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Unlike regular stock options, the entire gain on disposition of stock purchased from exercising ISOs qualifies for long-term capital gain tax if two conditions are met. The sale must occur more than one year after the option exercise and more than two years after the option grant date. If either of these circumstances is not met, some gain is taxed at the rate of ordinary compensation. The amount included as taxable compensation is the difference between the option exercise cost and the stock's market value on the exercise date. Unless the qualified holding period is met, this compensation income is incurred in the year the stock is sold.
AMT
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No amount is added to ordinary compensation when ISOs are exercised and the stock is not sold in the same year it was acquired. Regular income tax is therefore unaffected. However, in the exercise year, an AMT adjustment is made for the difference between the ISO exercise cost and the market value of the acquired stock upon exercise.
When the stock is sold after the acquisition year, another AMT adjustment is made. The adjustment upon sale is made whether or not the qualified holding period is met.
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Basis
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Basis in the stock is the cost to exercise the ISOs if the qualified holding period is met. Any amount taxed as ordinary compensation is added to basis.
There is a different basis for the stock under the AMT. The basis under that system is increased by the AMT adjustment made when the option was exercised and the stock was not sold in the same year.
Stock Price Increases
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A rising stock price increases the gain from holding the stock. If the stock is held for more than one year, the long-term capital gain tax rate applies. The long-term gain is largest if basis is not increased by any amount added as ordinary compensation. This requires meeting the qualified holding period--holding the stock for two years past grant date in addition to one year past the exercise date.
Stock Price Declines
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A stock price that declines below the basis will create a loss. Because this is a capital loss, there is a limit on how much may be deducted against non-capital income for any single tax year. If the stock is sold prior to the qualified holding period, the capital loss is increased by the amount taxed as ordinary compensation and thus added to basis. Consequently, a capital loss might not be entirely offset in one year by an amount taxed as ordinary compensation. The excess capital loss is carried over to future years.
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References
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