If you have been granted an option to purchase shares of stock by your employer, review the tax consequences before you exercise your option.

Incentive stock options are compensation to employees in the form of stock rather than cash. With an incentive stock option (ISO), the employer grants to the employee an option to purchase stock in the company at a predetermined price (i.e., the exercise or strike price) as soon as the option vests. ISOs can be taxed on the spread (i.e., the difference between the strike price and the purchase price of the option) and on any increase or decrease in the stock’s value when sold or otherwise disposed.

ISOs are taxed depending on how and when the stock is sold. Generally, the tax treatment of ISOs is as follows:

• A qualifying disposition of ISOs (i.e., an ISO disposed more than two years from the grant date and more than one year after the exercise date) 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.
• A non-qualifying disposition of ISOs can be taxed as compensation income (i.e., ordinary wages) and capital gains; the difference between the fair market value of the stock when exercised and the strike price is taxed as compensation income, whereas any profit in excess of compensation income is taxed as a capital gain.

CAUTION: If stock from ISOs isn’t sold within the same calendar year they’re exercised, the spread is treated as income for the purpose of calculating alternative minimum tax (AMT), but isn’t taxed for regular federal income tax. The spread for AMT purposes is the difference between the fair market value of the stock (measured on the date when the stock first becomes transferable) and the strike price of the option. This holding of the stock could trigger the payment of an AMT tax even though you didn’t sell the stock.

Don’t be caught off-guard at tax time; contact Flexible Accounting Services of the Triangle today to assist you with this complex area of tax law.