Updated for 2023. If you have incentive stock options, you’ll want to know how your equity compensation will be taxed. When you sell incentive stock options, it’s considered a qualifying or disqualifying disposition depending on your holding period. If you don’t sell ISOs by the end of the calendar year of exercise, the options can trigger the alternative minimum tax. Further, your employer is not required to withhold any amount at exercise or sale to cover your potential income tax liability. Here’s a primer on how ISOs are taxed.
If you have ISOs, work with your financial and tax advisor on tax planning strategies for your stock options. Managing equity compensation requires proper planning to avoid unwanted surprises.
How incentive stock options (ISOs) are taxed
There is no tax due at grant, vesting, or exercise of incentive stock options. If you sell stock options for a gain, tax will be due the year in which the ISOs were sold. Your employer will not withhold taxes upon sale of the stock. You will want to coordinate your plans with your financial advisor and CPA prior to selling your stock options.
Tax treatment of incentive stock options at sale
When you sell ISOs, it’s considered either a qualifying or disqualifying disposition depending on how long you held the stock. If you meet the requirements for a qualifying disposition, you can benefit from tax savings, all else equal. To meet the criteria, you must hold the stock for at least 2 years from the grant date and at least 1 year after exercise. Everything else is a disqualifying disposition.
In addition to federal income tax and/or capital gains tax you may also need to pay tax at the state level.
Tax benefits of a qualifying disposition
A qualifying disposition generally means you’ll only pay long-term capital gains tax on the gain. For tax purposes, the gain is typically the sale price minus the strike price multiplied by the number of shares sold. Given that long-term capital gains rates are the most favorable, this can save considerably on your tax due.
Holding onto stock long enough to qualify for favorable tax treatment can mean paying less in tax. But there’s also the risk that the stock declines in value and you’re left with less or perhaps even a loss. Don’t let the tax-tail wag the dog.
What happens if you don’t meet the requirements for a qualifying disposition? It’s a disqualifying disposition.
If you don’t meet the holding period requirements for a qualifying disposition, it’s a disqualifying disposition. If you exercise and hold the shares, the disqualifying disposition is typically taxed as ordinary income and capital gains. The difference between the fair market value of the stock when you exercised and your strike price is considered regular income. It is not subject to payroll taxes. Obviously, if your shares are underwater or you have a loss, the rules are different.
Short-term capital gains apply if you hold the stock for less than a year before selling. If you keep the stock for more than a year, it’s a long-term capital gain. Capital gains are generally calculated as the difference between the price you sold the stock for and the value at exercise. In another words, your capital gain is any subsequent gain after exercising the stock options, but if you exercise and sell the stock right away, you shouldn’t have a capital gain to report.
Beware of the alternative minimum tax or AMT
Exercising incentive stock options could have indirect tax implications. If the stock isn’t sold before the end of the calendar year, it could trigger the alternative minimum tax. The AMT is a parallel tax calculation. In years where you are subject to the AMT, certain tax deductions may be disallowed so the taxpayer pays more in tax than they would under the traditional system. Again, you’ll want to work with your accountant in advance to run the numbers. Some states, including California, also have their own alternative minimum tax too.
Other tax considerations for ISOs
There are other caveats to be aware of which often require coordination with your CPA and financial advisor. For example, there’s an annual vesting limit of $100,000 per year for incentive stock option tax treatment, based on the market value of the ISOs at the time of grant. Also, the taxation of stock options can change depending on how stock options are treated during a merger or acquisition.
While ISOs have tax benefits, it still may not be beneficial to hold the stock that long on a risk-adjusted basis. Learn more about tax planning for ISOs.
To learn more about how Darrow may be able to help you manage your stock options, schedule a call with an advisor today.