Tax Treatments for Stock Options
Several distinctive tax treatments are possible for stock options, depending upon the type of option and when an employee chooses to sell the acquired stock. Employers usually grant regular stock options but occasionally provide incentive stock options (ISOs), which possess special tax characteristics.
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Taxed as Compensation
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Income tax is payable for the year that regular stock options are exercised. The “bargain element” is taxed as compensation. This taxable amount is the difference between the cost to exercise the option and the market value of the stock acquired.
The entire gain on stock that is sold at the time of option exercise is the bargain element. All of this gain is taxed as compensation and added to the employee’s W-2. For stock that is sold upon exercising ISOs, the gain is taxed just like regular options. The bargain element is treated as compensation income. There is no capital gain tax treatment for stock sold upon option exercise.
Capital Gain Tax Treatment
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Stock acquired from exercising either type of option that is sold one year or less from the exercise date receives short-term capital gain treatment. Stock sold more than one year after exercising options is taxed at a more favorable rate as a long-term capital gain. For regular options, the bargain element taxed as compensation in the year of exercise and is added with the option exercise cost to determine basis. For ISO-acquired stock, the bargain element is taxed as compensation in the year of stock sale and added to basis.
ISO-acquired stock has a special benefit if the sale occurs more than one year after exercise and more than two years after the option grant date. In that case, no amount is taxed as compensation in the year of sale and added to basis. Instead, long-term capital gain treatment is applied to the difference between sale proceeds and the option exercise cost.
An exception applies for ISOs if the sale proceeds are less than the stock’s market value on the exercise date. The amount added as compensation is the actual gain instead of the larger bargain element. The resulting capital gain is zero. The entire gain is taxed as compensation.
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Alternative Minimum Tax
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If none of the stock acquired by exercising ISOs is sold, the bargain element is not taxed in the year of exercise. However, the bargain element is added to income in the exercise year using the Alternative Minimum Tax (AMT) method.
Sellers of ISO-acquired stock in years subsequent to the exercise year make another AMT adjustment. The adjustment accounts for the fact that AMT income was added in the earlier year of exercise. That prior adjustment added to the basis of the stock under AMT. Hence, the stock has a different basis under AMT than under the regular income tax system.
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References
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