Accounting for Incentive Stock Options

Incentive stock options require different accounting than regular employee stock options.

Incentive stock options (ISO) have tax benefits distinguishing them from regular options to purchase employer stock. ISO accounting requires a record of stock purchase price upon exercising the options, market value of the stock upon exercise and sale proceeds. The dates of grant, exercise and sale are also required.

Exercising ISOs

No regular income tax is assessed on exercising ISOs. Under the alternative minimum tax (AMT), the difference between the stock purchase price and market value upon exercise is taxable upon exercise of ISOs. If you sell stock acquired with ISOs at the time of option exercise, the tax accounting is the same as regular stock options.

Nonqualified Stock Sale

When stock is sold less than one year after ISO exercise, the difference between sale proceeds and market value on the exercise date is short-term capital gain. The difference between market value on the exercise date and purchase price is counted as ordinary income. The same tax rate applies to both.

Long-term gains are taxed at favorable rates if the stock is held more than one year after purchase. There are no additional ISO tax benefits unless the sale is also two years after the ISO grant date. If both conditions are not met, the difference between the stock purchase price and market value upon exercise is taxed as ordinary income in the year of stock sale. Capital gain accounting is applied to the difference between market value upon exercise and sale proceeds.

Qualified Stock Sale

ISO tax benefits are incurred when the sale of stock occurs more than one year after the exercise date and more than two years after the option grant date. Long-term capital gain accounting applies to the difference between the purchase price and sale proceeds.

When stock acquired with ISOs is sold after the exercise year, a lower capital gain is calculated under AMT. The stock's AMT cost basis is higher by the amount of AMT adjustment in the exercise year.

References

• Internal Revenue Service: Publication 525