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ISO-specific Taxes
ISOs are subject to the long-term capital gains tax when the stock is sold if holding periods are satisfied. There is no taxable income to the option recipient at the time of grant or exercise. To receive the preferential tax treatment, ISO shares can only be sold more than two years after the option grant date (the date the option is received) and more than one year after they are exercised. If the options are sold sooner, they are considered “disqualified” and taxed as NSOs. A lot can happen in the stock market in a short amount of time. If a stock's value drops during the holding period, the option recipient is out of luck.
Alternative Minimum Tax
No tax is applied upon the exercise of an ISO. However, the difference between the market value of the stock at exercise, and the exercise price, is used as an item of adjustment for purposes of the Alternative Minimum Tax (AMT). The AMT is a flat tax rate imposed on an adjusted amount of taxable income above a certain threshold. Taxpayers with incomes above the threshold whose regular income tax is below the amount of AMT must pay the higher AMT amount.
NSO-specific Taxes
The U.S. Internal Revenue Service doesn't give NSOs preferential tax treatment. With NSOs, ordinary income tax is applied to any gain at the time of exercise. Prior to exercising, the difference between exercise price and current market value is a tax-deferred profit. When the stock is sold, there is a separate tax on the gain derived from the stock’s value at exercise and its market value at the time of sale. The tax rate is based on the length of time the stock is held, the holding period.
| Shares held under a year | Shares held over a year |
|---|---|
| After exercising and holding for a year or less, selling is considered a short-term capital transaction and taxed at the ordinary income tax rate. | Once exercised, holding over a year and then selling, the profit or loss incurs a long-term capital loss or gain. |
Let's take a look at two NSO exercise situations:
Ben is granted 100 NSOs at $11 per share. He decides to exercise all his options on the same day when the market price is $48.
- How much does he owe in taxes if he exercises and sells on the same day?
- How much does he owe if he holds and sells after 1 year? (The market price is now $70.)
| Exercise and sell option same day | Exercise option, sell after 1 year |
|---|---|
|
# of options vested: 100 Exercise price: $11 Market price on day of purchase : $48 Sale price (on same day as purchase): $48 Tax basis: W-2 ordinary income: $37 ($48 - $11) Capital gain: $0 ($48 - $48) For a person in the 22% tax bracket: Tax on exercise = (22% x $37) x 100 = $814 Capital Gains Tax = 22% x $0 = $0 Amount owed in Taxes: $814 Net gain: $3,700 – $814 = $2,886 |
# of options vested: 100 Exercise price: $11 Market price on day of purchase : $48 Sale price: $70 Tax basis: W-2 ordinary income: $37 ($48 - $11) Capital gain: $22 ($70 - $48) For a person in the 22% tax bracket: Tax on exercise = (22% x $37) x 100 = $814 Capital Gains Tax = (15% x $22) x 100 = $330 Amount owed in Taxes: $1,144 Net gain: $5,900 – $1,144 = $4,756 |
In the first scenario, Ben does not pay a capital gains tax since he did not hold the shares by conducting a cashless exercise. He still pays a tax on the spread between the exercise price and the market price on the day of purchase.
In the second scenario, Ben pays more in taxes since he waited for the sale price to increase to $70. Because he waited at least one year to sell from the day of exercise, the (lower) long-term capital gains tax is applied which resulted in a 65% increase in net gain for the additional year that he held on to the stock.
Memory Jogger
When are U.S. NSOs taxed?