Tax Treatment of Incentive Stock Options

Incentive stock options tax treatment was created by the Revenue Act of 1950. The stock option grants became popular in the following decade as a form of compensation for executives and employees. These contracts give the holder the right but not the obligation to buy or sell a stock at an agreed-upon price and date. Through the 1960s, 1980s, and 1990s, stock options continued to dominate diminishing the popularity of restricted shares and performance shares that were introduced in the 1960s and 1970s.

However, as of 2014, stock options are no longer the most common form of long-term equity incentive rewards for executives. Employee stock options as well as performance shares and restricted stock units (RSUs) are equity incentive rewards. Companies award them as a way to motivate their employees to be more productive. The stock options for employees give the employees the right to purchase the shares of the company over a period of time and according to a vesting schedule.

By owning stock options, the employees can receive a percentage of ownership in the company. Employees are usually offered two types of stock options which are incentive stock options and non-qualified stock options (NSO). One of the major advantages of being offered an ISO stock option is the tax treatment that the option receives. ISOs are different from NSOs, mainly because of this tax treatment.

In this article, we will discuss the incentive stock options tax treatment and requirements. But first, let’s look at how incentive stock options work.

Related: ISO vs NSO which is better?

Incentive stock options can be issued by public companies and private companies. They are common as a form of equity compensation in private start-up companies and a form of executive compensation for public companies. Generally, incentive stock options are usually awarded only to top management and highly-valued employees.

ISOs are issued on a beginning date, called the grant date, and carry an expiration or maturity date. The employee exercises their right to buy the stock on or before the expiration date depending on the stock options style. An American option style allows the early exercise of stock options wherein the employee can exercise before or on the expiration date. The European option style, on the other hand, doesn’t permit early exercise, thus, the employee can only exercise their options on the expiration date.

Stock options are usually granted at a price set by the employer or company known as the grant price, strike price, or exercise price. The strike price may be approximately the price of the shares at the time of issue. This is the price that the employee must pay to purchase one share of the stock. The grant price for an employee’s incentive stock option grant must be set to the current 409(a) fair market value of the common shares.

Once employees exercise their options, they have the freedom to either sell the stock immediately or wait for a period of time before doing so. Unlike non-qualified stock options, the offering period for ISOs is always 10 years, after which the options expire.

Nevertheless, incentive stock options usually have a vesting schedule that must be satisfied before the employee can exercise the options. In some cases, the standard three-year cliff vesting schedule is used wherein the employee becomes fully vested in all of the options issued to them at that time. While, other employers use the graded vesting schedule, wherein the employees become vested in one-fifth of the options granted each year, starting in the second year of the grant. Then, the employee is fully vested in all of the options in the last year of the grant.

Related: Warrants vs stock options

Incentive stock options tax treatment

Incentive stock options tax treatment was created by the Revenue Act of 1950. The ISOs have more favorable tax treatment than NSOs. With incentive stock options, tax treatment depends on the dates of the transactions; that is when the employee exercises the options to buy the stock and when they sell the stock. The favorable tax treatment of incentive stock options is that the employee does not have to report income when they receive a stock option grant or when they exercise the option.

The employee reports the taxable income only when they sell the stock. More so, the income could be taxed at capital gain rates, ranging from 0% to 23.8%, depending on how long the employee holds the stock. This tax rate is typically a lot lower than the regular income tax rate. The price break (difference) between the strike price that the employee pays for the stock and the fair market value of the stock on the day of exercising the options is known as the bargain element.

With ISOs, you do have to report the bargain element as taxable compensation for Alternative Minimum Tax (AMT) purposes in the year that you exercise the options unless you sell the stock in the same year. This is not the case for NSOs, wherein you must report the bargain element as taxable compensation in the year you exercise your options, and it is taxed at your regular income tax rate, which can range from 10% to 37%.

However, in order to receive favorable tax treatment, the employee must meet certain obligations. There are two types of dispositions for ISOs, qualifying disposition and disqualifying disposition. For a qualifying disposition, the sale of ISO stock must be made at least two years after the grant date and held one year after the options were exercised. These conditions must be met in order for the sale of stock to be classified as a qualifying ISO for favorable tax treatment. Whereas, the sale of ISO stock that is not made at least two years after the grant date and not held one year after the options were exercised is a disqualifying disposition.

Conclusively, the incentive stock options tax treatment is that, on exercise, the employee does not pay ordinary income tax nor employment taxes on the difference between the fair market price and the strike price of the shares issued. Though the employee may owe a substantial ATM if the shares are not sold in the same year, especially if the bargain element is large, on the order of $50,000 or more. If the shares are rather, held for 1 year from the date of exercise and 2 years from the date of grant (a qualifying disposition), then the profit made is taxed entirely as a long-term capital gain, at a maximum rate of 23.8% as opposed to the regular income rate of 37%.

Taxation rules for ISOs

• Even though ISOs have more favorable tax treatment than NSOs, they require the holder to take on more risk by holding the stock for a longer period of time for the holder to be able to receive optimal tax treatment.
• For a qualifying disposition, the sale of ISO stock must be made at least two years after the grant date and held one year after the options were exercised for favorable tax treatment.
• If the shares are sold before the required holding period in the same tax year, it is a disqualifying disposition.
• For a disqualifying disposition, the difference between the fair market price at the time of exercise minus the strike price is taxed as ordinary income, and any additional gain on top of the strike price is taxed as a short-term capital gain which is subject to the same tax rate as ordinary income and is also subject to the 3.8% net investment income tax.
• If the incentive stock option is sold above the strike price but below the fair market price at the time of exercise in the same tax year, the income is recognized solely as ordinary income. If the shares exercised are not sold in the same tax year, even if a disqualifying disposition is made, the holder must calculate to see if any alternative minimum tax is owed.
• Even if the ISO holder disposes of the stock within a year, it is possible that there will still be marginal tax deferral value as compared to NQSOs.
• Ordinary income from incentive stock options, compared to income from NSOs or wage income is also not subject to payroll taxes such as FICA.
• An employer generally does not claim a corporate income tax deduction upon the exercise of its employee’s ISO, unless the employee does not meet the holding-period requirements and sells early, making a disqualifying disposition. But with NQSOs, the employer is always eligible to claim a deduction upon the exercise of its employee’s NQSO.

Example of ISO tax treatment upon exercise and sale

Let’s look at an example of taxation of an ISO upon exercise and sale. This example will look at a scenario of early exercise and after vesting schedule which will highlight the incentive stock options AMT tax treatment.

Assume, on January 1, 2017, Miss Mary, an employee of a private company, Techbuddy, received a grant of 1,000 shares at a strike price of $1 to vest monthly over 4 years.

Early exercise

The company can choose to offer Miss Mary the option of early exercise where she can purchase the entire grant before vesting, perform an 83(b) election and notify the IRS within 30 days with form 83(b). However, if Mary performs an early exercise and does not fully vest the shares, the exercise price for the unvested shares is returned.

Let’s assume Miss Mary decides to early exercise her stock options and exercises 500 of the options to purchase Techbuddy’s stock, which is valued at $15, after a year in 2018. Exercising the 500 options means she will purchase the shares for $500 which is valued at $7,500 in the market.

A profit of $7,000 can be made if Miss Mary sells her shares. However, based on a federal AMT rate of 28%, this can cost Mary $1,960 tax (i.e 28% of $7,000) on the income from the sale of the shares. Due to this, she can choose to reduce the federal tax percentage by holding onto the exercised shares bought for another year to meet the requirements for long-term capital gains tax which will cost her less than the $1,960 she would have paid for AMT.

In 2021 and 2022, 0%, 15%, or 20%, are the capital gain tax rates depending on the income of the individual filing while the federal AMT is levied at 26% and 28%. From this example, it is evident that early exercising before her option vests starts the clock earlier for Mary’s holding period for long-term capital gains.

After vesting period: Incentive stock options AMT tax treatment

In this example, Miss Mary does not exercise early and waits till her options vest.

On January 1, 2021, Techbuddy performs a 409(a) valuation and values the common shares at $200 each. Say, after 4 years, on February 1, 2021, Miss Mary elects to exercise and purchase her vested shares.

Miss Mary has fully vested the shares and in order to exercise, she must pay a price of $1 per share to purchase the shares. She pays $1,000 to exercise the ISOs and the current difference between the common share price, $200, and the strike price, $1, gives a bargain element of $199 per share:

i.e $199 x 1,000 shares= $199,000

This means Mary could have a total bargain element of $199,000. Now, if she doesn’t sell the shares by the end of 2021, this $199,000 bargain element together with the employee’s ordinary income is taxable under alternative minimum tax at a maximum rate of 28%, which is then imposed if it is higher than the ordinary tax.

Let’s say on May 1, 2021, Techbuddy raises additional capital in an initial public offering, where the shares are traded on the New York Stock Exchange at $400 per share. Based on this new development, assuming on December 1, 2021, Mary sells 500 of the 1,000 shares at a price of $350 per share. Therefore, an ordinary income of $175,000 is generated from the sale. This makes these shares a disqualifying disposition because they were sold before a 1 year holding period.

On December 31, 2021, the remaining 500 shares that were exercised but not sold would create a bargain element of:

($200- $1) x 500= $99,500

This bargain element of $99,500 may be taxed under the alternative minimum tax. But mary waits till February 1, 2022, and sells the remaining 500 shares at $300 per share. This means she now owes long-term capital gains tax on $149,500

i.e ($300 – $1) x 500=$149,500.

If Mary paid AMT in 2021, she may be entitled to recoup any AMT credit generated in the tax year 2022.

See also: Put option example and problems

Requirements for incentive stock options tax benefits

There are requirements for classification as ISO in order to qualify for tax benefits. The employer or employee has to meet several requirements in order to qualify the compensatory stock option as an incentive stock option. For a stock option to qualify as ISO and be able to receive the special tax treatment under Section 421(a) of the Internal Revenue Code, it must meet the requirements of the Code when granted and at all times, starting from the grant date till its date of exercise.

The incentive stock options requirements include:

1. The option may be granted only to an employee; that is, grants to independent contractors or non-employee directors are not permitted.
2. The employee must exercise the option while he or she is still employed or no later than three months after the termination of employment. If the employee is disabled, the three-month period is extended to one year, and in the case of death, the option can be exercised by the legal heirs of the deceased until the expiration date.
3. The option must be granted under a written plan document identifying clearly the total number of shares that may be issued and the employees who are eligible to receive the options. This must be approved by the stockholders within 12 months before or after plan adoption.
4. Each option must be granted under an ISO agreement, which must be written and the restrictions placed on exercising the ISO must be listed.
5. Each option must set out an offer to sell the underlying stock at the option price and time frame during which the option will remain open.
6. The option must be exercisable only within 10 years of grant and the option must be granted within 10 years of the earlier adoption or shareholder approval.
7. The exercise price of the option must equal or exceed the fair market value of the underlying stock at the time of grant.
8. At the time of grant, the employee must not, own shares representing more than 10% of the voting power of all outstanding shares, unless the option exercise price is at least 110% of the fair market value and the option from the time of the grant expires no later than five years.
9. The ISO agreement must categorically state that ISO cannot be exercised by anyone other than the option holder. It cannot be transferred by the option holder except by will or by the laws of descent.
10. The aggregate fair market value of stock bought by exercising ISOs that are exercisable for the first time by any individual during a calendar year cannot exceed $100,000. If it does, Code section 422(d) provides that such options are treated as non-qualified stock options.

Risk on the tax treatment of incentive stock options

In as much as the incentive stock options tax treatment seems catchy, there could be a drawback to it. For the employee, the disadvantage of the ISO is the greater risk formed by the waiting period before the options can be sold. More so, there is a possible risk of making a huge enough profit from the sale of ISOs stocks that can trigger the federal alternative minimum tax (AMT). This usually applies only to employees with very high incomes and very substantial options awards.

Related: Equity options

NQSO vs incentive stock options tax treatment

Incentive stock options are a type of ESO that is usually taxed at capital gain rates rather than the higher rate for ordinary income. Whereas, a non-qualified stock option (NSO) is a type of ESO that is taxed as ordinary income when exercised.

The favorable tax treatments that ISOs receive make them different from NSOs. ISOs have the tax advantage that no income is reported when the option is exercised and, if certain requirements are met, the entire gain from the sale is taxed as long-term capital gains. Whereas, NSOs upon exercise result in additional taxable income to the recipient and are also not subject to the $100,000 limit rule per year, unlike ISOs. Some of the value of non-qualified stock options may be subject to earned income withholding tax as soon as they are exercised. However, with incentive stock options, no reporting is necessary until the profit is realized.

Depending on how soon NQSOs are sold after they are exercised, the profits on the sale may be taxed as ordinary income or as a combination of ordinary income and capital gains. They do not qualify for the special treatment accorded to incentive stock options. Furthermore, NSOs are frequently preferred by employers because the issuer is allowed to take a tax deduction that is equal to the amount the recipient is required to include in his or her income.

Last Updated on November 8, 2023 by Nansel Nanzip Bongdap