Exercising Incentive Stock Options
When you work for a corporation, having a stake in its performance is a great motivation. That's why companies grant valued employees stock options. The option is a contract that gives you the right to buy company stock at a guaranteed price called the exercise or strike price. Incentive stock options (ISOs) are a type of employee stock option that offers tax advantages. You do need to know and follow some IRS rules in order to get these tax benefits.
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Description
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The big attraction of incentive stock options is that the profits are taxed at low long-term capital gains tax rates. This is different from the other type of employee stock options, nonstatutory options. NSOs are subject to ordinary income taxes. Companies may grant ISOs only to employees. The exercise price cannot be less than the market price of the stock on the day the options are awarded.
Exercise
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Once a company grants you incentive stock options, you must wait at least one year before exercising the options to buy shares, according to IRS rules. However, company vesting requirements in an ISO contract may stipulate that an employee wait longer. To exercise the options, you pay the exercise price for the shares. For example, if the exercise price is $20 per share, that's what you pay, even if the market price has risen to $40. The IRS limits you to exercising $100,000 worth of ISOs per year.
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Sale
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Before the profits on your ISOs can qualify for long-term capital gains tax rates, you must wait at least one more year after you've exercised the options to buy the shares. Suppose you received ISOs with an exercise price of $20 per share and exercised them when the stock price was $40 per share, then sold the shares for $50 per share after waiting the required time. Your total profit is $50 minus $20, or $30 per share. All of this profit is considered a long-term capital gain and taxed accordingly.
Considerations
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An added advantage of ISOs is that, unlike NSOs, tax is not normally due in the year the options are exercised, but in the year the shares are sold. One exception is if you are subject to the alternative minimum tax. If that's the case, you may have to pay taxes in the year of exercise and recover the money in future years. If for some reason you don't watt the required year to exercise the options or the additional year before selling the shares, it is called a disqualifying distribution. You can still collect the profits, but they will be taxed as ordinary income, not as long-term capital gains.
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