Equity Compensation Advisor

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:

1.  At the time of exercise, the option holder does not report any income for regular tax purposes.
2.  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.
3. The bargain element from the exercise or profit from the sale is not subject to income tax withholding or Social Security tax.
4. 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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Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

As I had indicated in my November 2010 blog, it is normally preferable to exercise ISO shares early in the year to start the one-year holding period to qualify for the long-term capital gain rate.

This blog will explain the reason behind the early exercise and the impact on AMT (alternative minimum tax). The primary advantage provided by ISO shares is the ability to have the bargain element (gain upon exercise) taxed as a long-term capital gain instead of as ordinary income.

Currently, the long-term capital gain rate is less than half of the top marginal tax rate, so the tax savings is substantial. In order to be eligible for the ISOs to be taxed at a long-term capital gain rate, the option holder must meet both of these requirements:

1. No disposition occurs within two years from the option grant date.
2. No disposition occurs within one year from when the option is exercised and transferred to the option holder.

When these two criteria are met, the bargain element is taxed as a long-term capital gain. This special holding period is often referred to as a qualifying sale.

The second requirement—shares from exercise must be held for a year—is challenging. The bargain element is subject to AMT in the calendar year of exercise. If the value of the shares was to drop substantially before the one-year holding period ends, the option holder may own shares that are worth less than the AMT tax liability. There lies the rub.

The question becomes: “How do I obtain a long-term capital gain rate after exercising my ISO shares without the added risk of the shares going down?” The answer is: “Exercise ISO shares as early in the calendar year as possible.” The tax code indicates that if ISO shares are sold before the end of the calendar year in the year of exercise, the bargain element would be subject to ordinary income and the AMT would be eliminated.

By exercising ISOs early in the year (January, February), the exposure of the stock dropping substantially to meet the one-year holding period is only a month or two versus six months or longer for ISOs exercised in June or beyond.

Dan’s Moral: The early ISO exerciser gets a head start on the special holding period and is ahead of the game.

Daniel Langworthy does not provide tax advice.  Please consult a qualified tax advisor.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC