Understanding employer stock options requires identifying the type of option, the tax consequences of option exercise and the necessary record keeping. There are two types of employer stock options--regular stock options and Incentive Stock Options (ISOs). Tax consequences occur when options are exercised and when the acquired stock is sold. Stock acquired from an option exercise that is held for future sale requires maintaining the correct cost basis for the shares.
Employers customarily provide regular stock options. An employee benefits from exercising these options when the exercise cost is less than the market value of the acquired stock.
ISOs embody special tax characteristics when the acquired stock is held more than one year after exercise and more than two years after the option grant date. This is referred to as a "qualified" sale because it qualifies for the tax benefits. When ISO-acquired stock is sold prior to this qualified period, the shares are treated like those acquired from exercising regular stock options.
Tax Upon Exercise
For regular stock options, the difference between exercise cost and value of acquired stock is taxed even when none of the stock is sold. This "bargain element" is taxed as ordinary compensation.
No amount is added to ordinary compensation when ISOs are exercised and the stock is not sold. Regular income tax is therefore unaffected. However, in the exercise year, the bargain element is added to income under the Alternative Minimum Tax (AMT) calculation. This only affects taxpayers subject to tax under that system.
Tax Upon Sale
Stock acquired from exercising either type of option that is sold one year or less from the exercise date receives short-term capital gain treatment. Stock sold more than one year after exercise is taxed at a more favorable rate as a long-term capital gain. For regular options, the bargain element taxed as compensation in the year of exercise is included in the cost basis along with the option exercise cost.
For ISO-acquired stock, the bargain element is taxed as compensation in the year of stock sale and included in cost basis. However, if the ISO-acquired stock is a qualified sale, the bargain element is not taxed in the year of sale and therefore not added to the cost basis. In a qualified sale, long-term capital gain is the difference between sale proceeds and the option exercise cost.
An exception applies for ISOs, if the sale proceeds are less than the stock's market value on the exercise date. The amount added as compensation is the actual gain instead of the larger bargain element. The resulting capital gain is zero. The entire gain is taxed as compensation.
When stock acquired from ISO exercise is sold in a different year than the exercise year, another AMT adjustment is required. The stock has a different cost basis under AMT than under the regular income tax system. Under AMT, the cost basis of the stock does include the bargain element that was added to AMT income in the exercise year.
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