Taxation of Incentive Stock Options (ISO)

This type of transactions are common for our clients in San Francisco, and increasing in New York, Chicago, Los Angeles, Boston, Austin, and other cities where we have a large client base. Because of our extensive experience with these types of clients, we have seen many variations and scenarios of how the tax effects ultimately are shown on your return. We will attempt to summarize some of these below. Please feel free to leave comments with questions & we will be happy to address.

In order to know the tax implication of ISOs, you need to know the following:

·         Grant date: the date when you are granted the options

·         Exercise date: the date when you exercise the option and purchase the stocks

·         Sale date: the date when you dispose your stocks

·         Exercise price: the price you paid to purchase the stocks

·         Selling price: the fair market value of stocks when you dispose them

You can usually get this information from Form 3921.

There are 2 types of ISOs. One is Qualified Incentive Stock Option and the other is Nonqualified Incentive Stock. In most cases, Qualified ISO is more tax favorable so how do you determine the type of your ISOs? Here is a flowchart.

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Scenario 1: Sell the stock at least one year after the exercise date at least two years after the grant date.

In the year of your exercise, you will need to make an adjustment for the Alternative Minimum Tax (AMT), which is usually called “Bargain Element”. Bargain element is the difference between the exercise price and Fair Market Value of the stocks when you exercise the options. It can trigger an AMT liability. However, no AMT adjustment is needed if you sell and exercise Qualified ISO in the same year. You will report the sale on your Schedule D as a long-term sale. The gain will be taxed at long-term capital gain tax rate. The cost basis of your stock is the actual price you paid.

If the sale and the exercise of the options occur in different years, you must make an AMT adjustment in the year of sale as well. You should report a negative bargain element on your Form 6251.

 

Scenario 2: Sell the stocks within one year after the exercise date

Nonqualified ISO dispositions will be taxed in two ways: compensation income (subject to ordinary income rate) and capital gain or loss (subject to short-term or long-term capital gain rate).

If the sale and exercise occur in the same year, the bargain element will be included in the total wage (box 1) on your W2. It is taxed at the ordinary income rate. At the same time, you will also report the sale on your Schedule D. The gain will be taxed at short-term capital gain rate. The cost basis will be the actual price you paid plus the bargain element so that you will not be double taxed.

If the sale and exercise occur in different year, there will be a positive AMT adjustment in the year of exercise and a negative AMT adjustment in the year of sale.

 

AMT consequences

AMT is reported and calculated on Form 6251. If you are subject to AMT in the year of sale, the AMT adjustment can reduce your tax liability. If you are not subject to AMT in the year of sale, you can carry forward the unused AMT credit to the future year. Under the new tax law, the AMT credit carryforward will not be available in 2018. It is scheduled to come back in 2019, 2020 and 2021 but would only allow the taxpayer to claim a refund of 50% to the extent the credits exceed regular tax for that year. Any remaining carryforward can then be used in 2020.

 

None of this material is tax, legal, or investment advice and is only conversational material provided for discussion purposes only. We are happy to assist with this at our contact information below or through emailing george@dimovtax.com

 

 

 

 

George Dimov