Key Points
- The taxation of incentive stock options (ISOs) can be complicated and confusing for many individuals.
- ISOs are a type of stock option that can provide certain tax advantages if certain requirements are met.
- ISOs are subject to two different types of taxes: ordinary income tax and capital gains tax.
- ISOs must be held for a certain period of time in order to receive the tax benefits, known as the holding period.
- If the holding period is not met, the ISOs may be subject to a disqualifying disposition and lose their tax advantages.
- The amount of ordinary income tax owed on ISOs depends on the bargain element, which is the difference between the exercise price and the fair market value of the stock.
Introduction
Incentive stock options (ISOs) are a type of employee stock option that can offer some tax advantages. If you receive any Incentive Stock Options, be thoughtful in how you use them. You may be able to avoid paying taxes on the stock you purchase until you sell it which could be at a rate that’s potentially as low as 0% on gains. This article will answer questions such as how Incentive stock options (ISOs) are taxed, when are incentive stock options taxed, and explain the taxation of incentive stock options.
What are Incentive Stock Options?
Incentive stock options are a type of employee stock option that provides certain tax benefits. Unlike non-qualified stock options, incentive stock options are subject to special rules and regulations.
In order to qualify for the favorable tax treatment, incentive stock options must be granted by the employer to employees and must meet certain other conditions. If these conditions are met, then the employee will not be taxed on the Exercise of the Option to purchase stock and will instead only be taxed when they sell the stock.
The main benefit of incentive stock options is that they offer potential tax savings. When done correctly, incentive stock options can provide employees with a valuable tool to grow their wealth without being unduly burdened by taxes.
How Do Incentive Stock Options Work?
Incentive stock options are a type of employee stock option that can be granted to employees, directors, and officers of a company. Unlike non-qualified stock options, incentive stock options are subject to special tax rules.
When you exercise an incentive stock option, you purchase shares of the company at a predetermined price. This price is typically set at the fair market value of the stock on the date the option is granted. If you hold onto the shares for at least one year after exercise and two years from the grant date, you will be eligible for long-term capital gains treatment when you sell the shares. This means that you will pay a lower tax rate on any profits you realize from the sale.
If you do not hold onto the shares for at least one year after exercise, or if you sell the shares before holding them for two years from the grant date, then you will be subject to short-term capital gains taxes. These rates are generally higher than the long-term capital gains tax rate.
Incentive stock options can provide a valuable source of income and potential profits for employees of a company. However, it is important to understand the tax implications before exercising your options.
Do you owe tax on incentive stock options?
There are two times you should be concerned with the taxation of incentive stock options: the exercise of the incentive stock option and the subsequent sale of the stock.
Taxation of Incentive Stock Options: Exercise
Good news! When you exercise Incentive Stock Options (buy the stock at the set price in the contract), you won’t owe any ordinary income tax, however, you may owe Alternative Minimum Tax (AMT).
What is Alternative Minimum Tax and How Do You Know If You Owe Alternative Minimum Tax After Exercising Your Incentive Stock Options?
Alternative Minimum Tax is a separate tax that requires some taxpayers to calculate their tax liability twice—first, under ordinary income tax rules, then under the AMT—and pay whichever amount is highest.
When calculating your income under AMT, you’ll have to add AMT preference amounts to your earned income to see if the combined total exceeds the AMT exemption. In this scenario, the difference between your set purchase price and the market price of your company stock is an “AMT Preference Item” which could potentially put you over the limit.
The problem with this is, not everyone has a boatload of cash sitting around to pay AMT with, and the stock they bought may very well be private if their company isn’t traded on the NYSE, yet so they can’t sell it either. As a result, they find themselves cash-poor, temporarily until they can find a loan to cover the new tax bill resulting. This right here is why people are concerned with the taxation of Incentive Stock Options.
How do I calculate alternative minimum tax (AMT)?
The alternative minimum tax runs parallel to the standard tax system, but it has a different tax rate structure and eliminates some common tax breaks. This is generally how the calculation works:
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Calculate your taxable income, but with fewer tax exclusions and tax deductions, as dictated by the AMT rules (IRS Form 6251 has the details on which tax breaks get the ax in the AMT calculations.)
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Once you have that AMT version of your taxable income, subtract the AMT exemption amount.
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Multiply what’s left by the appropriate AMT tax rates. The AMT has two tax rates: 26% and 28%. (Compare these to the seven federal income tax brackets, ranging from 10% to 37%.) Which rate you pay depends on how high your AMT taxable income is. (Again, IRS Form 6251 has the details.)
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Subtract the AMT foreign tax credit, if you qualify for it. What’s left is your income tax under the AMT rules.
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If your income tax under the AMT rules is higher than your income tax under the regular rules, you pay the higher amount. This basically determines who has to pay alternative minimum tax.
Taxation of Incentive Stock Options: Subsequent Sale of Stock Acquired In Exercise
The next concern you should have about the taxation of Incentive stock options is when you decide to sell the shares. When you sell the shares you acquired by exercising your Incentive stock options, you will owe capital gains tax which can defer depending on how long you owned the stock before selling it. You may qualify for long-term capital gains (currently between 0% – 20%, federal) or short-term capital gains which will be taxed at the same income tax rates the income you earn working is taxed at.
If you have additional questions about the taxation of your Incentive stock options, you should speak to a tax advisor or expert equity compensation advisor like Progress Wealth Management.
When are incentive stock options taxed?
Incentive stock options are generally taxed when they are exercised. However, there may be some instances where they are taxed earlier – such as when they are sold or transferred.
The tax treatment of incentive stock options depends on a number of factors, including whether the option is qualified or non-qualified and how long you hold the shares before selling them.
Non-qualified incentive stock options are subject to taxation at both the federal and state level. The tax rate on these options is generally higher than for qualified options.
When estimating your taxes, it is important to consider all of your income sources – including any from incentive stock options. By understanding how these options are taxed, you can make sure that you are paying the correct amount of taxes and avoid any penalties.
Conclusion – Taxation of Incentive Stock Options
The taxation of incentive stock options can be complex, and there are many different rules that apply. However, in general, the tax treatment of incentive stock options is favorable to the taxpayer.
There are some restrictions and rules that apply to incentive stock options, so it’s important to consult with a tax advisor before exercise. However, overall, the taxation of incentive stock options is generally more favorable to the taxpayer than other types of employee stock options.
