Got ISOs? You need to understand their tax treatment

Incentive stock options allow you to buy company stock in the future at a fixed price equal to or greater than the stock’s fair market value on the grant date. If the stock appreciates, you can buy shares at a price below what they’re then trading for.

ISOs must comply with many rules but receive tax-favored treatment:

  • You owe no tax when ISOs are granted.
  • You owe no regular income tax when you exercise ISOs provided that you continue to hold the shares.
  • If you sell the stock after holding the shares at least one year from the exercise date and two years from the grant date, you pay tax on the sale at your long-term capital gains rate. You also may owe the 3.8% net investment income tax.
  • If you sell the stock before long-term capital gains treatment applies, a “disqualifying disposition” occurs and any gain is taxed as compensation at ordinary-income rates.

If you hold your ISO shares after the exercise of your options, it is likely that you may owe some Alternative Minimum Tax in the year of exercise. For purposes of calculating the AMT, the difference between the exercise price that you pay and the fair market value of the stock at the date of exercise is added to your taxable income. If you have a relatively high household income, and take advantage of itemized deductions for state income taxes and property taxes, the exercise of ISOs will likely trigger AMT. Although some or all of this AMT may be recovered in later years as an AMT credit, it can still be a significant and often overlooked cost associated with the exercise of ISOs.

If you’ve received ISOs, contact us. We can help you develop a strategy on how to obtain the most value from your options and minimize the associated tax liability.

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