In order to calculate the tax treatment of ISOs, you'll need to know:
- Grant date: the date the ISOs were granted to the employee
- Strike price: the cost to purchase a share of stock
- Exercise date: the date on which you exercised your option and purchased shares
- Selling price: the gross amount received from selling the stock
- Selling date: the date on which the stock was sold.
Qualifying dispositions of incentive stock optionsA qualifying disposition of ISOs simply means that the stock, which was acquired through an incentive stock option, was disposed more than two years from the grant date and more than one year after the stock was transferred to the employee (usually the exercise date). There's an additional qualifying criteria: the taxpayer must have been continuously employed by the employer granting the ISO from the grant date up to 3 months prior to the exercise date.
Tax treatment of exercising incentive stock optionsExercising an ISO is treated as income solely for the purpose of calculating the alternative minimum tax (AMT), but is ignored for the purpose of calculating the regular federal income tax. The spread between the fair market value of the stock and the option's strike price is included as income for AMT purposes. The fair market value is measured on the date when the stock first becomes transferable or when your right to the stock is no longer subject to a substantial risk of forfeiture. This inclusion of the ISO spread in AMT income is triggered only if you continue to hold the stock at the end of the same year in which you exercised the option. If the stock is sold within the same year as exercise, then the spread does not need to be included in your AMT income.
Tax treatment of a qualifying dispositions of incentive stock optionsA qualifying disposition of an ISO is taxed as a capital gain at the long-term capital gains tax rates on the difference between the selling price and the cost of the option.
Tax treatment of disqualifying dispositions of incentive stock optionsA disqualifying or nonqualifying disposition of ISO shares is any disposition other than a qualifying disposition. Disqualifying ISO dispositions are taxed in two ways: there will be compensation income (subject to ordinary income rates) and capital gain or loss (subject to the short-term or long-term capital gains rates).
The amount of compensation income is determined as follows:
- if you sell the ISO at a profit, then your compensation income is the spread between the stock's fair market value when you exercised the option and the option's strike price.
- Any profit above compensation income is capital gain.
- If you sell the ISO shares at a loss, the entire amount is a capital loss and there's no compensation income to report.