How are stock options taxed?

Ordinary income tax and capital gains tax (CGT) are the two main types of taxes you need to know if you’re granted a stock option by your employer.

The tax treatment of stock options depends on the type you’re granted – incentive stock options (ISOs) or non-qualified stock options (NSOs or NQSOs). In this article, we’ll spell out how these two stock options are taxed with examples.

• Taxes on stock options
• NSO tax treatment at exercise and sale
• ISO tax treatment at exercise and sale
• Summary: How are stock options taxed?

Taxes on stock options

For NSOs (with a fair market value that cannot be readily determined), the tax implications are simpler – ordinary income tax at exercise and CGT at sale. If you hold your shares long enough before selling, your gains may be considered long-term and taxed at a lower rate at sale.

For ISOs, no income is recognized for the regular tax at exercise but you may have to pay an Alternative Minimum Tax (AMT). If you satisfy the holding period requirement, you only have to pay long-term CGT at sale. Otherwise, you’ll pay ordinary tax and short-term capital gains tax – if any – at sale.

The rate for the ordinary income tax is almost double that of the long-term CGT, so optimizing your plan to exercise and sell your assets can result in lower tax liabilities.

Table: Different taxes may occur in a stock option’s life cycle.

How are non-qualified stock options taxed at exercise?

When exercising your NSOs, you’ll need to pay ordinary income tax on the NSO spread – the market price at exercise minus the exercise price. In this case, you’ll owe federal, state and local income taxes as well as payroll taxes on the spread.

You must report this amount as a compensation element when filling out your tax return for the year you exercise your NSOs.

NSO tax example:

• Exercise price: $3 x 100 shares = $300
• Fair market value at exercise: $8 x 100 shares = $800

Your employer usually helps facilitate tax withholding. Since the exercise of NSOs is considered compensation, they result in a tax deduction for the company.

How are non-qualified stock options taxed at sale?

There are two types of NSO sales – 1) after holding shares for more than one year of exercising and 2) within one year of exercising. Type 1) has a favorable tax treatment (see Example 1, below) because the long-term CGT rate is lower.

Some people want to sell their shares sooner as they may want to secure the profit or cover the exercise costs by selling right away (see Example 3).

Example 1. Holding period > 1 year of exercising:

• Exercise date: 07/01/2021
• Sale date: 07/31/2022
• Exercise price: $3 per share
• Fair market value at exercise: $8 per share
• Sale price: $10 per share (Total shares: 100)

Example 2. Holding period =< 1 year of exercising:

• Exercise date: 07/01/2021
• Sale date: 01/01/2022
• Exercise price: $3 per share
• Fair market value at exercise: $8 per share
• Sale price: $10 per share (Total shares: 100)

Example 3. Selling stock right after exercising:

• Exercise date: 07/01/2021
• Sale date: 07/01/2022
• Exercise price: $3 per share
• Fair market value at exercise: $8 per share
• Sale price: $8 per share (Total shares: 100)

This approach allows you to pay exercise costs with the immediate sale proceeds, secure the profit and diversify your financial portfolio.

Let’s have a look at ISO tax treatment.

How are incentive stock options taxed at exercise?

At exercise, the ISO spread (FMV on exercise minus exercise price) is NOT taxed as ordinary income but it is subject to the Alternative Minimum Tax (AMT). As the name suggests, it’s an alternate calculation to your regular tax liability. The AMT may be triggered when income is exempt from regular federal income taxes – your ISO spread at exercise is one such income item.

You need to report the spread amount as income for the AMT adjustment on IRS Form 6251. But, if you exercise and sell your shares within the same year, then no AMT adjustment is required.  (Source: IRS Instructions to Form 6251).

Being subject to AMT doesn’t mean you have to pay AMT liability, as you need to do some math to determine your liability. To do so, you’ll need to compare your ordinary income tax with your tentative minimum tax (TMT). Since AMT is the excess of the TMT over the regular tax, the AMT is owed only if the TMT for the year is greater than the regular tax for that year (Source: IRS). Here are a couple of examples.

Case 1:
– Ordinary income tax: $300,000
– TMT: $340,000

Since your TMT is greater than your ordinary income tax (as the result of ISO exercise), you’ll pay an ordinary tax of $300,000 and an AMT of $40,000 ($340,000-$300,000).

Case 2:
– Ordinary income tax: $300,000
– TMT: $280,000

Since your ordinary income tax is now greater than your TMT, you’ll only pay an ordinary tax of $300,000. No AMT will be paid in this case.

(Source: Adam Frank, Managing Director, Head of Wealth Planning and Advice, J.P. Morgan)

1. Adding the ISO spread (FMV on exercise minus exercise price) to your total taxable income (and making certain other adjustments to income) = Alternative Minimum Taxable Income (AMTI)
2. Subtracting the AMT exemption amount (for tax year 2022, $75,900 for singles and $118,100 for married couples filing jointly) from (1)
3. Multiplying the amount computed in (2) by the appropriate AMT tax rate (26% for AMTI below $206,100 for married couples filing jointly and 28% for income above the threshold)
4. Subtracting the AMT foreign tax credit = TMT

If your regular tax is higher than your TMT each year, you don’t have to pay AMT. That may explain why some people haven’t heard of AMT. But, if you decide to exercise your ISOs this year and hold on to the shares, there is a good chance you’ll get an AMT bill.(https://www.irs.gov/taxtopics/tc556)
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How are incentive stock options taxed at sale?

There are two types of ISO sales – Qualifying disposition and Disqualifying disposition.

ISO qualifying disposition:

When you sell your ISOs at least 2 years after the grant date and at least 1 year after the exercise date, the difference between the exercise price and sale price is taxed as a long-term capital gain or loss. No ordinary income tax is charged in this sale.

• Grant date: 07/01/2020
• Exercise date: 07/01/2021
• Sale date: 07/31/2022
• Exercise price: $3 x 100 shares = $300
• FMV at exercise: $8 x 100 shares = $800
• Sale price: $10 x 100 shares = $1000

Since the sale and the exercise events didn’t occur in the same year, you must have reported an income adjustment (i.e. ISO spread) for AMT purposes in 2021 – the year you exercised your stock options. In 2022 – the year you sold your shares, you will have a negative adjustment for AMT purposes, because your AMT basis in the stock (FMV at exercise) is likely higher than your regular tax basis (exercise price).

ISO disqualifying disposition:

When you sell stock acquired through ISOs in 2 years or less from the grant date or 1 year or less from the exercise date, you lose ISO tax benefits. People do so rather than hold on to them because they may want to avoid AMT (see Example 2a), cover the exercise costs, or simply secure profits.

Example 2a) Sell all shares right after you exercise your ISOs
The first part to consider is the bargain element – sale price (= FMV at exercise) minus exercise price. It is taxed as ordinary income and subject to federal, state and local income taxes.

• Grant date: 07/01/2020
• Exercise date: 01/01/2021
• Sale date: 01/01/2021
• Exercise price: $3 x 100 shares = $300
• Sale price: $10 x 100 shares = $1000

The second part is short-term gains (since you sold the stock less than a year after exercising) that is the difference between the sale price and cost basis – the exercise price plus the bargain element in part I.

Since the cost basis and the sale price are the same, you end up reporting no gain or loss on the sale transaction itself here. Also, no income adjustment for AMT purposes is needed as the exercise and sale events are in the same year.

Example 2b) Sell share in the next calendar year but less than 1 year after the exercise date

The first part to consider is the lesser of

– The bargain element: the difference between the exercise price and the FMV at exercise, or
– The gain: the difference between the exercise price and the sale price

It is taxed as ordinary income and subject to federal, state, and local income taxes.

• Grant date: 07/01/2020
• Exercise date: 07/01/2021
• Sale date: 01/31/2022
• Exercise price: $3 x 100 shares = $300
• FMV at exercise: $8 x 100 shares = $800
• Sale price: $10 x 100 shares = $1000

Any additional gain is taxed as capital gain – Sale price minus cost basis (exercise price plus bargain element in part I)

In this case, you should have reported an income adjustment ($800 – $300 = $500) for AMT purposes in the year you exercised your stock options. You will have a negative adjustment to AMTI in 2022 – the year you sold your stock – because your AMT basis in the stock (FMV at exercise) is likely higher than your regular tax basis (exercise price).

ISO Tax Summary

NSO Tax Summary

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