Contributed by KeriC, FreeTaxUSA Agent, Tax Pro
The primary advantage of an incentive stock option (ISO) lies in its favorable tax treatment compared to other types of stock options. Qualifying ISOs only generate reportable income when the stock is sold.
Qualifying and Disqualifying ISO
A qualifying ISO meets the holding period requirements (2 years from grant, 1 year from exercise), taxed as capital gains upon sale, with no tax at exercise but potential alternative minimum tax (AMT) implications.
A disqualifying ISO, or disqualifying disposition, doesn’t meet the holding period requirements, and the discount at exercise is taxed as ordinary income in the year of sale, with any additional gain taxed as capital gains.
Qualifying ISO Tax Deferral
One of the most significant advantages of an ISO is that it allows employees to defer tax until the shares acquired through the options are sold. There is no taxable event upon exercise (assuming certain conditions are met), which means employees don’t owe regular income tax or payroll tax (e.g., Social Security and Medicare tax) at the time of exercise.
Qualifying ISO Capital Gains Tax Treatment
When ISO shares are sold after meeting the required holding period, the gains are generally taxed at lower long-term capital gains tax rates.
To have a qualifying disposition when you sell your stock, you'll need to hold the stock for:
- At least two years after the grant date AND
- At least one year after the exercise date
Not supported by our software at this time:
- Qualified ISO dispositions
- Calculating AMT due to exercising your ISOs for the year of exercise
- Any AMT adjustments needed in the year the ISO is sold
Our software does support ISO transactions that were sold in the same year they were exercised and therefore, not qualified.
Disqualifying Disposition
If you sell the ISO stock before the two-year grant date and one-year exercise date, the sale will be a disqualifying disposition and will be treated as a nonqualified stock option (NSO). That means the smaller of the bargain element (the difference between the exercise price and the market price on the exercise date) or the gain from the sale* is reported as compensation on your W-2.
*Sometimes the gain can't be used if it's a related party transaction, wash sale, or was gifted.
If your ISO is a disqualifying disposition, your employer reports the ordinary income to you as wages in Box 1 of your W-2. Check that your employer has included the correct ordinary income on your W-2. The W-2 may have an item in Box 12, or a note in Box 14. If you aren’t sure, call your employer's payroll department. If the income isn’t correctly included on your W-2, contact your employer to get a corrected W-2. If your employer did not report the ordinary income portion on your W-2, our software doesn’t support your tax situation.
For your disqualifying disposition of ISOs, you’ll likely receive a Form 1099-B but will not receive a Form 3921 or Form 3922. The sale will trigger ordinary income and capital gains income or loss, depending on the specific details. You may receive information from your brokerage or employer showing additional details of the sale for tax purposes.
Example
Let’s say you exercised an ISO and acquired stock with the following details:
- Exercise price: $20 per share
- FMV at exercise: $50 per share
- Sale price: $70 per share
- Number of shares: 10
- You sell the stock within 6 months of exercising.
- Your exercise date and sale date are within the same calendar year.
- Ordinary income: $50 (FMV) - $20 (exercise price) = $30 per share of ordinary income. This should be reported on your W-2.
- Capital gain: $70 (sale price) - $50 (FMV at exercise) = $20 per share. This would be reported on Schedule D and Form 8949 as a short-term capital gain. Our software will fill out Schedule D and Form 8949 for your return based on the information entered.
Here are the types of forms you may receive, helping you to properly report the ordinary income and capital gain from your disqualifying disposition.
The difference between the FMV at exercise ($50) and the exercise price ($20), multiplied by 10 shares, is $300. This amount should already be reported as ordinary income on the W-2, as shown below, and it doesn’t need to be reported again separately.
Follow this menu path to enter a W-2: Income > Wages (W-2).
Follow this menu path to enter Form 1099-B: Income > Investments and Savings > Add an Investment > Stock Sales (1099-B). Proceed to the Tell us about your stock sale screen. Below are screenshots of how the example would be entered.
We will need to adjust the cost basis on the tax return to reflect the FMV at the time of exercise. In this example, the correct adjusted basis is $500 (FMV of $50 × 100 shares), not $200, which is the basis is shown on the 1099-B.
With this information entered, Schedule D would report a $200 short-term capital gain ($700 proceeds - $500 basis = $200 gain) and Form 8949 would also be used to report additional details regarding the sale and adjustment.
