There are a number of companies (mostly in high-tech) that reward their employees with a form of deferred compensation called incentive stock options (ISOs). The tax rules for these stock options are complicated, but if you receive this kind of benefit, you need to understand the basic rules for them to be able to use them effectively. For some time I’ve wanted to discuss how profits from stock purchased via ISO exercises are taxed. This post, which will be the first of two parts, is more of a primer than an exhaustive discussion, but I hope it will be useful. (Keep in mind that ISO-related tax calculations can be complex; you should consult a tax adviser before implementing transactions involving ISOs).
A few definitions are needed to get us started:
Employee Stock Option – these options are technically “call options.” They’re private contracts that enable an employee to buy a specified number of shares of the employer’s stock at a certain price.
Option grant – this is a contract made by the employer offering an employee the opportunity to buy the shares.
Exercise price – this is the price, named in the grant, at which the employee can buy shares. The options become valuable when the company’s stock price rises above the exercise price.
Vesting – usually the employee is not able to buy shares immediately; the right to buy shares “vests,” or comes into effect, according to a specified schedule.
Grant duration – the period during which the employee may exercise the options. This is often as long as ten years from the grant date.
Qualified option – an option that meets the requirements (specified by the IRS) that enable an employee to receive special tax benefits when the option is exercised.
Employer-granted stock options are either Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NQSOs). Only ISOs can be tax-qualified, and in certain situations the qualified status of an ISO exercise can be lost.
Determining how the sale of stock purchased via an ISO exercise will be taxed generally requires knowing
- the option grant exercise price
- the fair market value (FMV) of the stock on the date when the option was exercised
- the price at which the stock thus purchased was eventually sold
- whether the sale of the stock is a “disqualifying disposition” (i.e. a sale, gift, or transfer of shares obtained via an ISO exercise that is done less than two years after the option was granted OR less than one year after the option was exercised)
Exercising an ISO can trigger taxes in the year of exercise as well as in the year when the stock is sold. The simplest (!) way to explain this is through a few examples. I’ll start with a situation in which the stock purchased via ISO is sold more than 2 years after the grant and more than one year after the option exercise.
On January 1 2004, you received an ISO grant of 1000 shares with an exercise price of $10 and it vested fully after 4 years.
On January 2, 2008, you exercised the option and bought 1000 shares. The fair market value of the stock that day was $35/share.
On January 3, 2009, you sold the stock for $45 per share.
In 2008 you needed to consider the impact of the ISO exercise on alternative minimum tax (AMT) liability. The exercise does not trigger regular income tax liability in 2008. However, because of this favorable tax treatment, you might have owed AMT on your 2008 return. For the AMT calculation, you would add $25/share ($35 – $10) times 1000 shares to your AMT income. Depending on other income and deductions, this could result in AMT liability.
[If the ISO exercise creates an AMT liability, it might also qualify you for an AMT tax credit that could be used in later years.]
We’re not done with tax consequences. In 2009, when you sell the stock – you must identify those shares specifically as the ones being sold – things get really interesting. Generally, part of the capital gain that you recognize for regular income tax purposes is SUBTRACTED from your AMT income in the year of sale. In the case described, when you sell, your gain for regular income tax purposes is a long-term capital gain of $35/share ($45 – $10), or $35,000. Your AMT capital gain is $10/share ($45 – $35), or $10,000, because the AMT tax basis and the regular tax basis are different. This difference results in a negative AMT income adjustment of $25,000 ($35,000 – $10,000). Thus in the year of the sale, your AMT income is reduced. You must still calculate the rest of your income and deductions in order to determine whether AMT is owed in 2009.
What all this means is that in the year of sale, you must calculate your capital gains and losses twice — once using Schedule D with your AMT basis, and then again using a second Schedule D with your regular tax basis — in order to determine the AMT income adjustment.
This special treatment gives rise to a possible tax-minimization strategy: one might decide to make a qualified sale of shares acquired via ISO in a year when a negative AMT income adjustment would reduce overall tax liability.
Alas, the example above is a fairly simple case. If the sale price is less than the FMV at exercise, the consequences are even less intuitive. Suppose that instead of selling at $35, the stock sold for $20/share. This creates an AMT capital loss of $15,000 ($15/share) and a regular tax capital gain of $10,000. Your AMT capital loss is limited to the amount of capital gain plus $3,000, so if there are no other gains or losses, in 2009 you would receive a negative AMT adjustment of $13,000 and an AMT loss carryforward of $12,000, to be used in future years.