Tax Implications of the Five Types of Equity Compensation, Part 5: Taxation of Incentive Stock Options – (ISO’s)
Taxation of Incentive Stock Options – ISO’s
In this, my fifth and final submission to the blog series on the taxation of different equity awards, we examine the “Taxation of Incentive Stock Options” or ISO’s, the benefits and tax implications.
Tax Benefits: Holders of ISO’s are eligible for certain potential tax benefits that are not available in the previously discussed equity awards. The main tax benefit of ISO’s is the ability to convert compensation income into long-term capital gain. In order to qualify for the long- term capital gain rate, the option holder must hold the stock for a specified period of time after exercise.
There are four tax benefits of ISO’s over other equity awards:
- At the time of exercise, the option holder does not report any income for regular tax purposes.
- If the option holder holds the shares long enough to avoid a “disqualifying disposition” (for future blog discussion) the bargain element (gain) will be taxed as long-term capital gain.
- The bargain element from the exercise or profit from the sale is not subject to income tax withholding or Social Security tax.
- If the shares are sold in a disqualifying disposition, they may still be able to limit the amount of income reported to the actual profit from the purchase and sale, versus a non qualified option that must report the actual gain at the time of exercise. This applies regardless if the shares drop in value after the exercise.
So exactly what are the potential tax implications when ISO’s are exercised? In most cases an option holder who exercises an ISO, and holds the shares beyond the end of the year of exercise, will be subject to AMT tax.
Dan’s Moral: ISO’s give the option holder the ability to convert the gain into long-term capital gains if the proper strategy is used.
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