Incentive stock options, or ISOs, may be awarded only to employees of a company or its subsidiaries. Profits from ISOs can be treated as capital gains for tax purposes if you meet Internal Revenue Service criteria. This is in contrast to nonstatutory, or nonqualified, employee stock option earnings, which the IRS defines as salary-like compensation. Capital gains tax rates for ISO profits give the employee a significant tax break.
ISO Tax Status
Employee stock options granted by your employer give you the opportunity to buy a stated number of shares of company stock at a guaranteed exercise price. Typically the options are good for several years. A waiting period might apply before you can exercise the options. When you exercise employee stock options, the difference between the exercise price and the market price is your profit and is called a “bargain element.” If the exercise price is $30 and the market price on the date of exercise has climbed to $55, the bargain element is $25 per share. For nonqualified stock options, or NSOs, the bargain element is treated as compensation and reported on your W-2 form. When you exercise incentive stock options, the bargain element can become a long-term capital gain.
ISO Holding Requirements
You must wait a minimum of one full year after receiving ISOs before exercising them to qualify for capital gains tax rates. Then you have to wait at least another full year before selling the shares. No taxes are due in the year that you exercise the options. You report ISO profits and pay taxes in the year the shares are sold. Assuming you follow these rules, the bargain element plus any gain that occurs after the options are exercised are long-term capital gains.
Additional ISO Rules
The IRS limits the dollar value of ISOs that become eligible for exercise in one year to $100,000. This dollar amount is figured using the fair market value of the shares on the date the options are granted. If you exercise ISOs amounting to more than $100,000, the excess is treated as nonstatutory options for tax purposes and does not qualify for capital gains tax rates. If you exercise the incentive stock options before both holding period requirements have been satisfied, the ISOs also revert to NSO status and lose the capital gains benefit.
Disqualified ISOs as Compensation
In the event ISOs are disqualified for some reason, they may still be profitable as nonstatutory options. The bargain element is taxable as ordinary income in the year of exercise. If you hold the shares for any length of time following exercise, they may gain in value. In this case, the difference between the market price on the date of exercise and the sale price is a capital gain. A post-exercise gain is short term if you sell the shares within a year. If you keep the stock for more than a year, any gain is long term.