One of the major benefits that many employers offer to their workers is the ability to buy company stock with some sort of tax advantage or built-in discount. There are several types of stock purchase plans that contain these features, such as nonqualified stock option plans. These plans are usually offered to all employees at a company, from top executives down to the custodial staff.
However, there is another type of stock option, known as an incentive stock option. which is usually only offered to key employees and top-tier management. These options are also commonly known as statutory or qualified options, and they can receive preferential tax treatment in many cases.
ISOs can usually be exercised at a price below the current market price and thus provide an immediate profit for the employee.
These are conditions that allow the employer to recall the options, such as if the employee leaves the company for a reason other than death, disability or retirement, or if the company itself becomes financially unable to meet its obligations with the options.
Whereas most other types of employee stock purchase plans must be offered to all employees of a company who meet certain minimal requirements, ISOs are usually only offered to executives and/or key employees of a company. ISOs can be informally likened to nonqualified retirement plans, which are also typically geared for those at the top of the corporate structure, as opposed to qualified plans, which must be offered to all employees.
Taxation of ISOs
ISOs are eligible to receive more favorable tax treatment than any other type of employee stock purchase plan. This treatment is what sets these options apart from most other forms of share-based compensation. However, the employee must meet certain obligations in order to receive the tax benefit. There are two types of dispositions for ISOs:
- Qualifying Disposition - A sale of ISO stock made at least two years after the grant date and one year after the options were exercised. Both conditions must be met in order for the sale of stock to be classified in this manner.
- Disqualifying Disposition - A sale of ISO stock that does not meet the prescribed holding period requirements.
Just as with non-statutory options, there are no tax consequences at either grant or vesting. However, the tax rules for their exercise differ markedly from non-statutory options. An employee who exercises a non-statutory option must report the bargain element of the
transaction as earned income that is subject to withholding tax. ISO holders will report nothing at this point; no tax reporting of any kind is made until the stock is sold. If the stock sale is a qualifying transaction, then the employee will only report a short or long-term capital gain on the sale. If the sale is a disqualifying disposition, then the employee will have to report any bargain element from the exercise as earned income.
The first sale of incentive stock is a disqualifying disposition, which means that Steve will have to report the bargain element of $15,000 ($40 actual share price - $25 exercise price = $15 x 1,000 shares) as earned income. He will have to do the same with the bargain element from his non-statutory exercise, so he will have $30,000 of additional W-2 income to report in the year of exercise. But he will only report a long-term capital gain of $30,000 ($55 sale price - $25 exercise price x 1,000 shares) for his qualifying ISO disposition.
It should be noted that employers are not required to withhold any tax from ISO exercises, so those who intend to make a disqualifying disposition should take care to set aside funds to pay for federal, state and local taxes, as well as Social Security, Medicare and FUTA.
Reporting and AMT
Although qualifying ISO dispositions can be reported as long-term capital gains on the 1040, the bargain element at exercise is also a preference item for the Alternative Minimum Tax. This tax is assessed to filers who have large amounts of certain types of income, such as ISO bargain elements or municipal bond interest, and is designed to ensure that the taxpayer pays at least a minimal amount of tax on income that would otherwise be tax-free. This can be calculated on IRS Form 6251, but employees who exercise a large number of ISOs should consult a tax or financial advisor beforehand so that they can properly anticipate the tax consequences of their transactions. The proceeds from sale of ISO stock must be reported on IRS form 3921 and then carried over to Schedule D.
The Bottom Line
Incentive stock options can provide substantial income to its holders, but the tax rules for their exercise and sale can be very complex in some cases. This article only covers the highlights of how these options work and the ways they can be used. For more information on incentive stock options, consult your HR representative or financial advisor.