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 tax overview helps you understand the taxes on your ISOs and what documents you or your tax advisor will need to file in the United States.

This guide provides general educational information about the U.S. federal tax rules applicable to ISOs and the IRS forms to be filed. However, the tax rules are complicated, and this guide is not specific to any one individual taxpayer's circumstances, and it does not cover all situations. We recommend you discuss your specific situation with a tax professional before filing your return. The forms discussed in this guide are publicly available from the IRS; however, using a tax professional, or at minimum, tax preparation software, is recommended to make the tax preparation and filing process easier and to help avoid costly errors.

In this guide, we'll cover:

• How do ISO taxes work?
• Alternative minimum tax and ISOs
• Tax document overview
• Tax reporting after you exercise options
• Reporting stock sales
• Completing your IRS tax forms

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 states 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 and holding ISO shares (for a qualified disposition) 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.

In the year you exercise and hold ISO shares, the spread (FMV of the share minus the "strike price") is added back to your income on IRS Form 6251 to determine if you owe AMT.

You'll use Form 6251 again when you sell your ISO shares. Because your basis for AMT is different from your regular tax basis, you may need to make an adjustment to prevent double taxation on the gain you previously paid AMT on.

If you paid AMT in a previous year, Form 8801 may allow you to claim an AMT credit to potentially reduce your current year's regular tax—this occurs in years when your regular tax is higher than your estimated AMT. (Consider talking with your tax advisor about strategies for using AMT credits in future years.)

Note: 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.

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.

After you sell shares and prepare to file your taxes, you need to report ordinary income and any gains/losses in the value of your shares.

For disqualified dispositions, your employer will include ISO income in box 1 of your W-2 and will send Form 3921 with details on the stock purchase.

Here's how your W-2 may look:

At tax time, you'll use several forms to report capital gains and losses from your stock sale:

1. 1099-B reports the details of your stock sale.
2. Form 8949 and Schedule D use the information from 1099-B to calculate your capital gains and losses.

When you sell ISO shares, you need to report gains or losses from the sale—also known as capital gains or losses.

Capital gains and losses are generally defined as the difference between what price you bought the stock for—or the cost basis—and what you sold it for (the sale proceeds).

The cost basis information can be found within the 1099-B section and the Realized Gain or (Loss) section of your 1099 Composite statement. The cost basis price reported to the IRS (i.e., the award price) can be found under the 1099-B portion, and your adjusted cost basis price or fair market value (FMV) can be found under the Realized Gain or (Loss) section. It is important to match transactions from the 1099-B section to the Realized Gain or (Loss) section when completing Form 8949.

On the sample form below, Schwab has indicated the areas to refer to when completing Form 8949.

Note: Do not use the information in this example. This sample form is not a full 1099 Composite statement, and Schwab has focused on the areas where stock plan transactions will be displayed for demonstrative purposes only.

The Realized Gain or (Loss) section of the 1099 Composite statement will contain the FMV you'll use on Form 8949 to adjust the cost basis. The adjusted cost basis will include the income portion. This is extremely important, as the tax on the income portion will be included on your W-2. In the example form below, Schwab has indicated important areas you'll need to refer to when completing your taxes.

Follow the IRS instructions for completing Form 8949 to adjust the cost basis on covered securities, then complete Schedule D with the totals from Form 8949.

Form 8949 requires the details of each capital asset transaction and helps you calculate capital taxes due. It includes two parts to separate short-term capital gains and losses from long-term gains and losses because they are subject to different tax rates.

Schedule D reports your capital gains or losses and the corresponding taxes due. The calculations from Schedule D are combined with your tax return Form 1040 and affect your adjusted gross income amount.