The timing and amount of tax assessment on employee stock options depends upon the type of option granted. Employees normally receive regular non-statutory options to purchase the company stock of their employer. But they may be granted Incentive Stock Options (ISOs) that have special statutory tax qualifications. Tax consequences occur when stock options are exercised and when acquired stock is sold.
Regular Options Upon Exercise
When regular options are exercised, income tax is assessed in the exercise year. The taxable amount is the “bargain element,” defined as the difference between the option exercise price and the market value of the acquired stock. This amount is treated as compensation and taxed as ordinary income.
When stock is sold upon exercise, the sale occurs at the stock’s market value. Therefore, the entire gain is taxed as ordinary income. There is no capital gain tax treatment.
ISOs Upon Exercise
Upon exercise of ISOs, the bargain element is not taxed as ordinary income. However, the bargain element is added to income tax calculation under the Alternative Minimum Tax (AMT) system. Only employees subject to AMT owe additional tax as a consequence of exercising ISOs.
When stock acquired from exercising ISOs is sold upon exercise, the character of the transaction for tax purposes is the same as exercising regular stock options. The bargain element is added to compensation and taxed as ordinary income. There is no capital gain tax treatment.
Regular Options Upon Sale
The tax on selling stock acquired from prior exercise of regular options depends upon how long the stock was held. Stock sold one year or less from the exercise date is taxed as a short-term capital gain. Stock sold more than one year after the date acquired is taxed as a long-term capital gain. The cost basis is the price paid to exercise the option plus the bargain element that was taxed as ordinary income in the exercise year.
ISOs Upon Non-Qualified Sale
Stock obtained from exercising ISOs receives special tax treatment if the shares are sold more than one year after the exercise date and more then two years after the grant date of the options. If both of these conditions are not met, the sale is non-qualified.
In a non-qualified sale, the bargain element is added to compensation and taxed as ordinary income in the year of stock sale. The cost basis is the exercise price plus the bargain element. Stock sold more than one year after exercising ISOs is taxed as long-term capital gain. Stock sold in one year or less after exercise, is taxed as short-term capital gain. However, if the sale proceeds are less than market value of the stock at exercise, only the actual gain is taxed as ordinary income. There is no capital gain.
When stock acquired from the exercise of ISOs is sold in the calendar year after exercising the options, another AMT adjustment is made. This AMT adjustment is made in the year of the sale because an adjustment was made in the earlier year of exercise.
ISOs Upon Qualified Sale
A qualified sale of stock acquired from exercising ISOs occurs more than one year after exercise and more than two years after the options were granted. In this case, the bargain element is not taxed as ordinary income. The difference between sale proceeds and exercise price is taxed as long-term capital gain. The cost basis is only the exercise price.
Since a qualified sale occurs more than one year after exercising ISOs, an AMT adjustment is made. This adjustment accounts for the stock having a different cost basis under AMT than under the regular income tax method. This is a consequence of the adjustment made under AMT in the exercise year.