Incentive stock options ISO are compensation to employees in the form of stock rather than cash. This transaction can happen as soon as the option becomes available to be exercised or is vested.
Strike prices are set at the time the options are granted, but options usually vest over a period of time. If the stock increases in value, an ISO provides employees with the ability to purchase stock in the future at the previously locked-in strike price. This discount in the purchase price of the stock is called the spread. Income from ISOs are taxed for regular income tax and alternative minimum tax, but are not taxed for Social Security and Medicare purposes.
How ISOs are taxed depends on how and when the stock is sold or disposed. Disposition of stock is typically when the employee sells the stock, but it can also include transferring the stock to another person or giving the stock to charity. A qualifying disposition of ISOs simply means that the stock, which was acquired through an incentive stock option, was disposed more than two years from the grant date and more than one year after the stock was transferred to the employee usually the exercise date.
An additional qualifying criteria is that you must have been continuously employed by the employer granting the ISO from the grant date up to 3 months prior to the exercise date. Exercising an ISO is treated as income solely for the purpose of calculating the alternative minimum tax AMTbut is options for the purpose of calculating the regular federal income tax. The fair market value is measured on the date when the stock first becomes transferable or when your right to the stock is no longer subject to a substantial risk of forfeiture.
This inclusion of the ISO spread in AMT income is triggered only if you continue to hold the stock at the end of the same year in which you exercised the option. If the stock is sold within the same year as exercise, then the spread does not need to be included in your AMT income. A qualifying disposition of an ISO is taxed as a capital gain at the long-term capital gains tax rates on the difference between the selling price and the cost of the option.
Stock ISO dispositions are taxed in two ways:. Be aware that employers are not required to withhold taxes on the exercise or sale of incentive stock options. Accordingly, persons who have exercised but not yet sold ISO shares at the end of the year may have incurred alternative minimum tax liabilities.
And persons who sell ISO shares may have significant tax liabilities that may not necessarily be paid for through payroll withholding. Taxpayers should send in payments of estimated tax to avoid having a balance due on their tax return. You may also want to increase the amount of withholding in lieu of making estimated payments.
Incentive stock options are reported on Form in three possible ways: Increase your AMT income by the spread between the fair market value of the shares and the exercise price. This can be calculated using options found on Form provided by your employer. The calculated spread is reported on Form Because you are recognizing income for AMT purposes, you will have a different cost basis in those shares for AMT than for regular income tax purposes.
Accordingly, you should keep track of this different AMT cost basis for future irs. For regular tax form, the cost basis of the ISO shares is the price you paid the exercise or strike price. For AMT purposes, your cost basis is the strike stock plus the AMT adjustment the amount reported on Form line Compensation income is reported as wages on Form line 7, and any capital gain or loss is reported incentive Schedule D and Form Compensation income may already be included on your Form W-2 wage and tax statement from your employer in the amount shown on box 1.
Some employers will provide a detailed analysis of your box 1 amounts at the top portion of your W If form compensation income has already been included on your W-2, then simply incentive your wages from Form W-2 box 1 on your Form line 7. If the compensation income has not already been included on your W-2, then calculate your compensation income, and include this amount as wages on line 7, in addition to the amounts from your Form W-2.
For disqualifying dispositions of ISO shares, your cost basis will be the strike irs found on Form plus any compensation income reported as wages. IRS Form is a tax form used to provide employees with information relating to incentive stock options that were exercised form the year.
Employers provide one instance of Form for each exercise of incentive stock options that occurred during the calendar year. Employees who had two or more exercises may receive multiple Forms or may receive a consolidated statement showing all exercises. The formatting of this tax document may vary, but it will contain the following information:. This information can be utilized to calculate your cost basis in the shares, to calculate the amount of income that needs to be reported for the alternative minimum tax, to calculate the amount of compensation income on a disqualifying disposition, and to identify the beginning and end of the special holding period to qualify for preferred tax treatment.
Incentive stock options have a special holding period to qualify for capital gains tax treatment. The holding period is two years from the grant date and one year after the stock was transferred to the employee. Form shows the grant date in box 1 and shows the transfer date or exercise date in box 2. Add two years to the date in box 1 and add one options to the date in box 2. If you sell your ISO shares after whichever date is later, then you will have a qualifying disposition and any profit or loss will be entirely a capital gain or loss taxed at the long-term capital gains rates.
The amount included for AMT purposes is the difference between the fair market value irs the stock and the cost of the incentive stock option. The cost basis of shares acquired through an incentive stock option is the exercise price.
Your cost basis for the entire lot of shares is thus the amount in box 3 multiplied by the number of shares shown in box 5. This figure will be used on Schedule D and Form Shares exercised in one year and sold in a subsequent year have two cost bases: The AMT cost basis is the regular tax basis plus the AMT income inclusion amount.
This incentive will be used on a separate Schedule D and Form for AMT calculations. If incentive stock option shares are sold during the disqualifying holding period, then some of your gain is taxed as wages subject to ordinary income taxes, and the remaining gain or loss is taxed as capital gains.
This compensation income amount is typically included on your Form W-2, box 1.