Incentive stock options (“ISOs”) are a great employee benefit. ISOs are very powerful because they provide the possibility of compensating employees at preferential long term capital gains rates instead of at ordinary income tax rates, and they avoid Social Security and Medicare taxes. ISOs can also help build wealth by allowing employees to purchase employer stock at a discount. However, ISOs can create several tax challenges, and reporting them on your tax return can be confusing.

Incentive Stock Options

Employers grant employees incentive stock options as an incentive to stay with the company. The company grants the employee an option to purchase the stock of the company at a certain price (the “exercise price” or the “strike price”). That price is no less than the company’s current stock price (i.e., the stock price on the grant date, defined below).

There is a $100,000 annual limit on the fair market value of stock subject to ISO treatment per employee. If an employee leaves the employer’s employment, he or she must exercise or forfeit their ISOs within three months.

Three dates matter when considering ISOs.

Grant Date: The date the employee is granted the option (i.e., the first date the employee has the option to purchase the stock at the strike price).

Exercise Date: The date the employee exercises the ISO (i.e., the date the employee purchases the stock of the company under the terms of the ISO at the strike price).

Disposition Date: The date the employee sells the stock acquired by the previous exercise of the ISO.

Tax Treatment

Grant: There is no tax consequence to the employee upon the grant of the ISO.

Exercise: Upon exercise, there is no income tax consequence to the employee. However, the difference between the fair market value of the ISO and its strike price is an adjustment that creates income for alternative minimum tax purposes (the dreaded AMT). Fortunately, the late-2017 tax reform bill increased AMT exemptions (i.e., the amount of income below which the AMT does not apply), thus reducing, but not eliminating, the potential negative impact AMT can have on ISO exercises.

Further, the AMT issue is removed if the exercise and later stock disposition occur in the same year. As a practical matter, it is often the case that the later stock disposition occurs almost instantaneously after exercise, which takes the AMT issue off the table.

Dispositions: ISOs have very favorable tax treatment upon disposition if the disposition of the shares satisfies both of the following rules.

The disposition is at least two years from the grant date; and,
The disposition is at least one year from the exercise date.

If both rules are satisfied, the employee has long term capital gain or loss upon the disposition of the shares. Long term capital gains are taxed at preferential rates for federal income tax purposes.

Example: Gary works for Acme Explosives, Inc. Acme grants Gary 10,000 ISOs at an exercise price of $10 per share on January 1, 2018. Gary exercises the ISOs on June 1, 2018 at a time when the fair market value of the stock is $15 per share. On February 1, 2020, Gary sells each share acquired through the ISO exercise at a price of $20 per share. Assume that Gary was not subject to AMT in 2018.

Because Gary sold the Acme shares at least one year after exercise and at least two years after the ISO grant, Gary’s sale qualifies entirely for long term capital gain treatment (creating a $100,000 capital gain — $200,000 sales proceeds less $100,000 basis) and creates no taxable ordinary income.

Early Dispositions

Often employees will dispose the ISO stock before the time required to get favorable income tax treatment. As a practical matter, employees often exercise the ISO and immediately sell the stock.

Employees are exposed to the economic performance of their employer through their job and possibly other equity holdings. Thus, they often want to reduce the risk associated with their employer’s performance and dispose of their ISO stock as soon as possible. Most view the tax cost as well worth it considering that (i) the employee immediately pockets (net of tax) the difference between the fair market value of the stock and the strike price, and (ii) the diversification benefits of investing the ISO proceeds into other investments.

If the employee disposes of the ISO stock early (referred to as a “disqualifying disposition”), what result? The difference between the strike price and the fair market value of the stock at exercise becomes ordinary income to the employee reported to the employee as compensation income included in Box 1 of the employee’s Form W-2. The remaining amounts create long or short term capital gain or loss.

Example: Angela works for Acme Anvils, Inc. Acme grants Angela 10,000 ISOs at an exercise price of $10 per share on January 1, 2019. Angela exercises the ISOs on June 1, 2019 at a time when the fair market value of the stock is $15 per share. On December 1, 2019, Angela sells each share acquired through the ISO exercise at a price of $20 per share.

Because Angela’s December 2019 sale violates both timing tests, Angela’s sale does not qualify for long term capital gain treatment. Thus, Angela has $50,000 of compensation income ($15 fair market value less $10 strike price times 10,000 shares) of ordinary compensation income. The remaining $50,000 of gain is short term capital gain.

Fortunately, the compensation income is not included in compensation income for purposes of Social Security and Medicare payroll taxes (and, thus, is not included in Boxes 3 and 5 on the Form W-2). Because Angela sold the ISO shares in the same year she exercised the ISOs, there will not be a separate AMT consequence of the ISOs.

Tax Reporting

Staying with Angela’s example, the $50,000 of ordinary income will be reported as compensation income in Angela’s Form W-2 Box 1, but not in Boxes 3 and 5. Box 14 should indicate “ISO DISQ” and $50,000 as the amount.

Angela should also receive two other tax reporting documents. First, Angela should receive a Form 1099-B. The form should indicate $200,000 of sales proceeds ($20 per share times 10,000 shares) and should indicate a basis of $100,000 (Angela’s historic cost basis, as she paid $10 per share for 10,000 shares). Angela should also receive a Form 3921. This form should indicate the exercise price per share ($10) and the fair market value per share on the date of the exercise ($15).

The IRS will expect to see at least two numbers on Angela’s tax return. First, the compensation income must be reported on Angela’s Form 1040 box 1. Second, the $200,000 stock sale should be reported on Schedule D and on Form 8949.

This is where it gets interesting. If Angela simply reports $200,000 as gross proceeds and $100,000 as basis on her Schedule D and her Form 8949, she is going to have a very bad tax result. Why? Angela’s W-2 includes $50,000 of the overall $100,000 of income she recognized on the ISO exercise and disposition. If she simply reports a $100,000 gain on her Schedule D/Form 8949, her total reported income will be $150,000, creating $50,000 in over-reported taxable income.

Thus, Angela must increase the basis she reports on Schedule D and Form 8949 by the $50,000 of ordinary compensation income reported on her Form W-2. Her Schedule D and Form 8949 should report both the $200,000 of gross proceeds and $150,000 of basis in the disposed of Acme shares.

Estimated Taxes

Even though the gain on a disqualifying disposition of an ISO is taxable as ordinary income in Box 1 of the Form W-2, there is no requirement that the employer withhold any income tax with respect to the gain. Thus, the onus falls to the employee to ensure he or she pays the proper amount of federal and state estimated income tax to avoid penalties. The good news is that there is a safe harbor under which employees can avoid underpayment penalties.

For federal income tax purposes, there will not be an underpayment of estimated tax penalty if the employee has paid in at least 90 percent of their current year total tax liability and/or 100 percent of their prior year total tax liability. If current year income is $150,000 or more, 100 percent becomes 110 percent.

Regardless of whether there is a qualifying disposition triggering long term capital gain or a disqualifying disposition triggering ordinary income, the employee should endeavor through a combination of estimated tax payments, additional workplace withholding, and/or additional spousal workplace withholding to ensure that he or she has withheld enough during the year to avoid federal and state underpayment penalties.

Conclusion

ISOs can be a great wealth building tool. But because of the tax rules and at times confusing tax reporting, they present a challenge. Anyone with ISOs (or with clients that own ISOs) should step back and fully understand the tax ramifications of selling them. It is often advisable to work with a professional advisor as you sell ISOs and manage the tax ramifications of the sale.

The Tax Challenges of ISOs

Incentive Stock Options

Tax Treatment

Early Dispositions

Tax Reporting

Estimated Taxes

Conclusion

Further Reading

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Incentive Stock Options

Tax Treatment

Early Dispositions

Tax Reporting

Estimated Taxes

Conclusion

Further Reading

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