Incentive Stock Option (ISO) Taxes: A Guide

If you've received incentive stock options (ISOs) from your employer, it gives you the right —but not the obligation—to buy shares of your company's stock at a specific price. As your company's value increases so may the value of your options.

One benefit to ISOs is their favorable tax treatment. However, navigating ISO taxes can be complex. This guide helps you understand the taxes on your ISOs and what documents you or your tax advisor will need to file in the United States.

For ISOs, your employer will issue you stock options on a specific date (known as the "grant date.") Generally, you will not be able to exercise (purchase or sell) stock until the end of a predetermined waiting schedule (known as the "vesting period.") Once your options are vested, you have the right to exercise options at a fixed price (the "strike price" or "award price") set when you were granted the options.

ISOs are typically taxed when you sell the stock, not at the exercise date. However, in some jurisdictions such as Pennsylvania and Ohio, local taxes can apply at exercise (see below section on AMT). In general, the tax treatment for ISOs depends on how long you hold the shares before selling them. Depending on this time period, the sale (known as "disposition") will be classified as either a qualified disposition or disqualified disposition. 

Qualified dispositions give you a more favorable tax treatment. To be a qualified disposition, you must meet two holding period requirements before selling the shares: 

1. The sale must be more than one year from the exercise date (i.e. the date you purchased the shares).
2. The sale must be more than two years from the grant date.                                                             

If both of these requirements are met, the gain realized from the sale of the shares will be eligible for taxation at the lower long-term capital gains tax rate. The taxable gain will be the difference between the strike price and the fair market value (FMV) when the shares are sold.

Disqualified dispositions don't qualify for preferential tax treatment since you sold the stock before meeting both holding period requirements listed above. With disqualified dispositions, you are taxed at ordinary income tax rates on the difference between the strike price and the FMV on those shares when you exercise. Any additional gains realized over the FMV will be taxed as a capital gain or loss depending on how long the shares were held after the exercise date.

While exercising an ISO doesn't trigger ordinary income taxes, it can potentially trigger the alternative minimum tax (AMT). As the name states, the AMT is an alternative way to calculate federal income taxes. Generally, AMT impacts high-income taxpayers, but it can also impact any taxpayers who exercise and hold a significant number of ISOs. Triggering AMT means that you may have to pay additional taxes in the year of the exercise. (Note: Consider talking with your tax advisor about using AMT credits in future years.)

If you believe that AMT could impact your ISO exercise, we recommend consulting with a tax professional before exercising your options to ensure you don't have additional taxes due.

ISO tax rules are complex, and we always recommend consulting with a tax advisor before taking any action or filing a tax return.

Here's an overview of the documents you may need when you're filing taxes and how you or your tax advisor will use them.