Some employers use Incentive Stock Options ISOs as a way to attract and retain employees. While ISOs can offer a valuable opportunity to participate in your company's growth and profits, there are tax implications you should be aware of. We'll help you understand ISOs and fill you in on important timetables that affect your tax liability, so you can optimize the value of your ISOs. A stock option grants you the right to purchase a certain number of shares of stock at an established price.
There are two types of stock options—Incentive Stock Options ISOs and Nonqualified Stock Options NSOs — and they are treated very differently for tax purposes.
In most cases, Incentive Stock Options provide more favorable tax treatment than Nonqualified Stock Options. If you have been granted stock options, make sure you know which type of options you received.
If you are not sure, take a look at your option agreement or ask your employer. The type of options should be clearly identified in the agreement. When you exercise Incentive Stock Options, you buy the stock at a pre-established price, which could be well below actual market value. The advantage of an ISO is you do not have to report income when you receive a stock option grant or when you exercise that option. You report the taxable income only when you sell the stock.
And, depending on how long you own the stock, that income could be taxed at capital gain rates ranging from 0 percent to With ISOs, your taxes depend on the dates of the transactions that is, when you exercise the options to buy the stock and when you sell the stock. The price break between the grant price you pay and the fair market value on the day you exercise the options to buy the stock is known as the bargain element. There is a catch with Incentive Stock Options, however: We'll explain more about the AMT later.
With Nonqualified Stock Options, you must report the price break as taxable compensation in the year you exercise your options, and it's taxed at your regular income tax rate, which in can range from 10 percent to 35 percent. Incentive Stock Option transactions fall into five possible categories, each of which may get taxed a little differently.
With an ISO, you can:. Each transaction has different tax implications. The first and last are the most favorable. The time at which you sell determines how the proceeds are taxed. If you can wait at least a year and a day after you purchase the stocks, and at least two years after you were granted the option to sell the stocks as described in item 5 above , any profit on the sale is treated as a long-term capital gain, so it is taxed at a lower rate than your regular income.
Your profit is the difference between the bargain price you pay for the stock, and the market price that you sell it for. This is the most favorable tax treatment because long-term capital gains recognized in are taxed at a maximum 15 percent or 0 percent if you're in the 10 percent or 15 percent income tax brackets compared to ordinary income tax rates which may be as high as 35 percent.
After tax rates may change depending on what Congress does. Sales that meet these one- and two-year time limits are called "qualifying dispositions," because they qualify for favorable tax treatment. No compensation is reported to you on your Form W-2, so you do not have to pay taxes on the transaction as ordinary income at your regular tax rate.
Category 5 is also a qualifying disposition. Now if you sell the shares before they meet the criteria for favorable capital gains treatment, the sales are considered "disqualifying dispositions," and you may end up paying taxes on part of the proceeds of the sale at your ordinary income tax rate, which in could be as high as When you sell the stock two years or less from the offering date, known as the "grant date," the transaction is a disqualifying disposition.
The amount reported is the bargain element, which is the difference between what you paid for the stock and its fair market value on the day you bought it. The reported compensation is taxed as ordinary income. Categories 2, 3 and 4 noted above are disqualifying dispositions. You do not report anything on your Schedule D Capital Gains and Losses because you have not yet sold the stock.
Your employer will not include any compensation related to your options on your Form W-2 either. Report this amount on your Form Alternative Minimum Tax, line This amount should already be included in the total wages reported in Box 1 of your Form W-2 because this is a disqualifying sale meaning you are disqualified from taking it as a capital gain and being taxed at the lower capital gains rate because you sold the shares less than a year after exercising the option.
If this amount is not included in Box 1 of Form W-2, add it to the amount you're reporting on your Form , line 7. Report the sale on your Schedule D, Part I as a short-term sale. The sale is short-term because not more than one year passed between the date you acquired the actual stock and the date you sold it. For reporting purposes on Schedule D:. Because you exercised the options and sold the stock in the same year, you do not need to make an adjustment for Alternative Minimum Tax purposes.
Unlike the previous example, the compensation is calculated as the lesser of the bargain element or the actual gain from the sale of the stock, because the market price on the day of the sale is less than that on the day you exercised your option. Report the sale on your Schedule D, Part I, as a short-term sale.
It's considered short-term because less than one year passed between the date you acquired the stock and the date you sold it. Because this sale did not occur in the same year as the year you exercised the options, you have to make an adjustment for AMT.
When you originally purchased the stock, you should have reported an income adjustment for AMT purposes in that year. Find out if this was the case by looking at Form Alternative Minimum Tax for the year that you purchased the shares. So what do you do in ?
We explain what you need to do in our section on Reporting an Incentive Stock Option Adjustment for the Alternative Minimum Tax below.
This amount should be included in the total wages shown in Box 1 of the Form W-2 from your employer because this is a disqualifying sale meaning that your gain does not qualify for capital gains treatment for which the rates are lower than for ordinary income in If this amount is not included in Box 1 of Form W-2, you still must add it to the amount of compensation income that you report on your Form , line 7.
You also must report the sale of the stock on your Schedule D, Part II as a long-term sale. It is long term because more than one year passed between the date you acquired the stock and the date you sold it.
So what do you do this year? You will have to report another adjustment on your Form We explain how you calculate your AMT adjustment in the section called Reporting an Incentive Stock Option Adjustment for the Alternative Minimum Tax below. This sale is a qualifying sale, because more than two years passed between the grant date and the sale date, and more than one year passed between the exercise date and the sales date.
Because this is a qualifying sale, the Form W-2 you receive from your employer will not report any compensation amount for this sale. Report the sale on your Schedule D, Part II as a long-term sale. It is long-term because more than one year passed between the date you acquired the stock and the date you sold it. Because this sale and the exercise of the options didn't occur in the same year, you must make an adjustment for AMT.
We'll explain how you calculate your AMT adjustment in the section below.
Cut Employee Stock Option Taxes With AMT Credit
If you buy and hold, you will report the bargain element as income for Alternative Minimum Tax purposes. Report this amount on Form Alternative Minimum Tax for the year you exercise the ISOs. And when you sell the stock in a later year, you must report another adjustment on your Form for the year of sale. But what is the adjustment you should report? The year-of-sale Form adjustment is added to the stock's cost basis for Alternative Minimum Tax purposes but not for regular tax purposes.
This is all pretty complicated and is better left to tax preparation software like TurboTax. In the year that you exercise an Incentive Stock Option, the difference between the market value of the stock on the exercise date and the exercise price counts as income under the AMT rules, which can trigger an AMT liability.
However, you will also generally earn an AMT credit in that year. You can use the credit to lower your tax bill in later years. However, there are limitations on when you can use an AMT credit. In some cases, AMT credits cannot be used for several years. For the tax year, long-term unused AMT credits are those that were earned in pre years.
Taxpayers with long-term unused credits from pre years can generally collect at least half their credit amounts by filing their returns, and the remainder can be collected by filing their returns. It is important to take a look at the whole picture of your capital gains and losses for AMT purposes when you sell stock that you purchased by exercising Incentive Stock Options.
If the market turns on you after you have exercised your options and the current value of your stock is now less than what you paid, you could still be subject to the Alternative Minimum Tax.
One way around that is to sell the stock in the same year that you bought it, creating a "disqualifying" disposition. That way you will not be subject to the AMT, but you would be subject to regular tax on the difference between your option exercise price and the sales price. It may be advisable to consult with a tax professional prior to making any transactions that involve ISO shares. TurboTax Premier Edition provides extra help with investments, so you can track and calculate your gains and losses—and TurboTax calculations are guaranteed accurate.
Your employer is not required to withhold income tax when you exercise an Incentive Stock Option since there is no tax due under the regular tax system until you sell the stock. Be sure to plan for the tax consequences when you consider the consequences of selling the stock.
For additional information, see IRS Publication Investment Income and Expenses Including Capital Gains and Losses and Stock Options in IRS Publication Taxable and Nontaxable Income. From stocks and bonds to rental income, TurboTax Premier helps you get your taxes done right.
Employee Stock Purchase Plans. How to Report Stock Options on Your Tax Return. When to Use IRS Form for Stock Sales.
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Skip To Main Content. Incentive Stock Options Updated for Tax Year OVERVIEW Some employers use Incentive Stock Options ISOs as a way to attract and retain employees. What are Incentive Stock Options? Why are Incentive Stock Options more favorable tax-wise? How transactions affect your taxes Incentive Stock Option transactions fall into five possible categories, each of which may get taxed a little differently.
With an ISO, you can: Exercise your option to purchase the shares and hold them. Sell shares at least one year and a day after you purchased them, but less than two years since your original grant date. Sell shares at least one year and a day after you purchased them, and at least two years since the original grant date.
For reporting purposes on Schedule D: This should match the gross amount shown on your Form B you receive from your broker after the end of the year. You will not be allowed to report the lesser calculation as income for shares sold in a wash sale. A sale to a related party: This amount should be reported as the gross amount on the Form B that you'll receive from the broker that handled the sale. The resulting gain is zero. Reporting an Incentive Stock Option adjustment for the Alternative Minimum Tax If you buy and hold, you will report the bargain element as income for Alternative Minimum Tax purposes.
Unused AMT credits In the year that you exercise an Incentive Stock Option, the difference between the market value of the stock on the exercise date and the exercise price counts as income under the AMT rules, which can trigger an AMT liability. Consider the entire picture It is important to take a look at the whole picture of your capital gains and losses for AMT purposes when you sell stock that you purchased by exercising Incentive Stock Options. A word of caution Your employer is not required to withhold income tax when you exercise an Incentive Stock Option since there is no tax due under the regular tax system until you sell the stock.
Looking for more information? More in Investments and Taxes 5 Things You Should Know About Capital Gains Tax What Are Deductible Investment Interest Expenses?
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Introduction To Incentive Stock Options
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