Incentive Stock Options Taxation Explained: 5 Real-World Scenarios to Understand ISO and AMT Rules

Hi everyone, my name is Tan, and I am an independent CERTIFIED FINANCIAL PLANNER™ practitioner at TAN Wealth Management. Building on my 2019 article on incentive stock options (ISOs), this piece focuses on the taxation of ISOs. It draws insights from an article written by a TurboTax expert and reviewed by a TurboTax CPA. Citations and resources are available in this article. The goal of this article is to provide a clear understanding of how ISOs are taxed.

Navigating the taxation of Incentive Stock Options (ISOs) can be complex, but understanding the rules is essential for optimizing our financial strategy. This video breaks down five real-world scenarios, detailing how taxes apply at each stage—from exercising our options to selling our shares. We'll explore disqualifying versus qualifying dispositions, the role of the Alternative Minimum Tax (AMT), and how to calculate our cost basis and potential gains. Whether we're holding our shares for the long term or selling them within a year, this guide simplifies the process and helps us avoid common pitfalls. Let's dive in to master the intricacies of ISO taxation and make informed decisions about our equity compensation.

Example 1: Exercise Options and Hold the Shares

06/01/2020 —— 07/01/2021 —— Unsold

Regular Tax:
• No tax liability.
• Our employer will not include any compensation related to our options on our Form W-2.
• We do not report anything on Schedule D, Capital Gains and Losses.

AMT:
• The bargain element is the difference between the market price of the stock at the time of exercise and the exercise price.
• Report the bargain element as a positive AMT adjustment on Form 6251, Alternative Minimum Tax-Individual, line 2i.
• We should receive Form 3921, Exercise of an Incentive Stock Option Under Section 422(b) when we exercise our ISOs.
• The market price minus the exercise cost, and then times the number of shares.
($100 - $1) X 1,000 ISOs = $99,000.
• Report the bargain element of $99,000 as income for AMT purposes for tax year 2021.

Example 2: Exercise Options and Sell Shares Within the Same Calendar Year

06/01/2020 —— 07/01/2021 —— 12/31/2021

Regular Tax:
• Disqualifying Disposition. “A failure to meet the holding period requirements results in a disqualifying disposition of the stock purchased by exercising a Statutory Stock Option. In that event, the employee has compensation (ordinary income) on the date of the disqualifying disposition equal to the difference between the exercise price and FMV of the underlying stock on the date of exercise. If the stock at issue was restricted 11 (i.e., subject to a substantial risk of forfeiture) the income is the difference between the exercise price and the FMV on the date the restriction lapsed. In the event of a disqualifying disposition, the employer is entitled to a corresponding wage deduction. Pursuant to Treas. Reg. § 1.6041-2(a)(1), the compensation from a disqualifying disposition is considered wages, should be reported on the employee's Form W-2, and is deductible on the employer's income tax return. However, the income from disqualifying dispositions is not subject to FICA, FUTA or FITW. For information regarding employment taxes, see Notice 2002-47.”
https://www.irs.gov/pub/irs-pdf/p5992.pdf

• FICA (Federal Insurance Contributions Act)
- FICA taxes fund Social Security and Medicare programs.
- Employers and employees both contribute to FICA:
– Social Security: 6.2% (up to a wage base limit)
– Medicare: 1.45% (no wage base limit, but an additional 0.9% for high earners)
- Total FICA for an employee: 7.65% (6.2% + 1.45%), with the employer matching this.

• FUTA (Federal Unemployment Tax Act)
- FUTA funds federal unemployment benefits.
- Only employers pay FUTA taxes; employees do not contribute.
- FUTA rate: 6.0% on the first $7,000 of each employee's wages.
– Employers may receive a credit of up to 5.4%, reducing the effective FUTA rate to 0.6%.

• FITW (Federal Income Tax Withholding)
- FITW refers to the federal income tax withheld from an employee's paycheck based on:
– Earnings
– Filing status (e.g., single, married)
– Number of allowances (from W-4)
- The tax rate is determined by the IRS withholding tables and varies widely depending on the individual's situation.

• Disqualifying Dispositions. A disqualifying disposition generally occurs when an employee sells stock from incentive stock options (ISO) before meeting specific holding period requirements. The ordinary income from such a transaction is treated as wages but is not subject to FICA, FUTA, or FITW, although it is still subject to federal income tax when reported.
• Bargain element taxed as ordinary income, shown on W-2 or added to "Other Income" on Form 1040.
• The bargain element of $99,000 taxed as ordinary income is the gross price.
• The total cost basis is calculated by multiplying the actual price paid per share by the number of shares purchased, and then adding any amounts reported as compensation income. If there are fees relating to the purchase of the shares, the total cost basis is the exercise cost plus the bargain element.
($1 X 1,000) + $99,000 = $100,000.
• The sale price is the fair market value at sale times the number of shares
$100 X 1,000 = $100,000
• This gross amount should match our 2022 Form 1099-B.
• We should receive Form 1099-B from our broker after the end of the year. Be sure to include the exercise cost in our cost basis. It's important not to overlook this, as we don't want to pay taxes again on the exercise cost, which has already been taxed.
• Sale price - Cost basis = Short-term capital gain or loss reported on Schedule D
• $100,000 - $100,000 = $0

AMT:
• No AMT adjustment because we exercise the options and sell the shares in the same calendar year.

Example 3: Exercise Options, Sell in the Next Calendar Year and Within 12 Months of Purchase

06/01/2020 —— 07/01/2021 —— 05/01/2022

Regular Tax:
• Disqualifying disposition
• In the year-of-sale, the lesser of the bargain element or the actual gain from the sale of the stock is compensation income on Form W-2, taxed as ordinary income.
(Market price - Exercise price) X Number of shares = Bargain element
($100 - $1) X 1,000 = $99,000
(Sale price - Exercise price) X Number of shares = Actual gain from sale
($90 - $1) X 1,000 = $89,000
• The bargain element of $99,000 is higher than the actual gain from the sale of $89,000. Thus, the compensation income is limited to $89,000. $89,000 should be included as income on Form 1040 (1a or 1h), tax year 2022 (the year-of-sale).

• “In order to be taxed only on the lesser of the two calculations, ($99,000 vs. $89,000 in our example), the sale cannot be any of the following:
1. A wash sale: if you repurchase shares in the same company (such as through an employee stock purchase plan) within 30 days before or after the sale of the shares obtained from the exercise of the option, some or all of the sale will be considered a wash sale. You will not be allowed to report the lesser calculation as income for shares sold in a wash sale. You must report the full $99,000 as income.
2. A sale to a related party: If you sell the shares to a related party (a member of your family, or a partnership or corporation in which you have more than a 50 percent interest), you must report the full $99,000 as income.
3. A gift: If you gave the stock to an individual or a charity, rather than selling the shares, you must report the full $99,000 as income.”
https://turbotax.intuit.com/tax-tips/investments-and-taxes/incentive-stock-options/L4azWgfwy#reporting

• Details of the transaction will be reported on Schedule D.
• Sell shares within 12 months of exercising is a short-term sale.
• Sale price X Shares sold = Sales price
$90 X 1,000 = $90,000
The broker should report $90,000 on Form 1099-B, tax year 2022 (in the year-of-sale).
• The cost basis is the actual price paid per share times the number of shares, and then plus the compensation amount reported in the year-of-sale Form 1040 (tax year 2022).
($1 X 1,000) + $89,000 = $90,000
Sale price of $90,000 - Cost basis of $90,000 = Gain of $0.

AMT:
• We should have reported the bargain element as income in the year we exercised our ISOs and did not sell the shares on Form 6251, Alternative Minimum Tax.
(Market price - Exercise price) X Number of shares = Bargain element
($100 - $1) X 1,000 = $99,000
Bargain element of $99,000 for tax year 2021.
• In the year-of-sale, Form 6251, an AMT adjustment is added to the stock’s cost basis for Alternative Minimum Tax purposes, but not for the regular tax purposes.

(Sale price - Exercise price) X Number of shares = Actual gain from sale
($90 - $1) X 1,000 = $89,000
Actual gain on sale - Bargain element = Net gain
$89,000 - $99,000 = -$10,000 adjustment for AMT purposes? It's not clear in the TurboTax article if it's a negative AMT adjustment. If the formula is the same as in example 5, the $10,000 should be a negative AMT adjustment unless there is an exception to the rules. As mentioned at the beginning of the article, I draw insights from the TurboTax article. I also uploaded this content and left out the AMT calculation in Example 3 into a large language model (LLM) to see what the answer would be and the information matches this calculation.
• This scenario introduces the rule of being taxed on the lesser of the bargain element or the actual gain from the sale of the stock, in the year-of-sale. I often see this scenario occur with companies that went public through an initial public offering (IPO) via a special purpose acquisition company (SPAC).

Example 4: Exercise Options and Sell at Least 1 Year After Purchase but Less Than 2 Years from Grant

06/01/2020 —— 04/01/2021 —— 05/01/2022

Regular Tax:
• Disqualifying disposition
• In the year-of-sale, the lesser of the bargain element or the actual gain from the sale of the stock is compensation income on Form W-2, taxed as ordinary income.
(Market price - Exercise price) X Number of shares = Bargain element
($100 - $1) X 1,000 = $99,000
(Sale price - Exercise price) X Number of shares = Actual gain from sale
($150 - $1) X 1,000 = $149,000
• The bargain element of $99,000 is lower than the actual gain from the sale of $149,000. Thus, the compensation income is limited to $99,000. $99,000 should be included as income on Form 1040 (1a or 1h), tax year 2022 (the year-of-sale).

• Details of the transaction will be reported on Schedule D.
• Sell shares after 12 months of exercising is a long-term sale.
• Sale Price X Shares Sold = Sales Price
$150 X 1,000 = $150,000
The broker should report $150,000 on Form 1099-B, tax year 2022 (in the year-of-sale).
• The cost basis is the actual price paid per share times the number of shares, and then plus the compensation amount reported in the year-of-sale Form 1040 (tax year 2022).
($1 X 1,000) + $99,000 = $100,000
Sales price of $150,000 - Cost basis of $100,000 = Gain of 50,000.

AMT:
• We should have reported the bargain element as income in the year we exercised our ISOs and did not sell the shares on Form 6251, Alternative Minimum Tax.
(Market price - Exercise price) X Number of shares = Bargain element
($100 - $1) X 1,000 = $99,000
Bargain element of $99,000 for tax year 2021.
• In the year-of-sale, Form 6251, an AMT adjustment is added to the stock’s cost basis for Alternative Minimum Tax purposes, but not for the regular tax purposes.
(Sale price - Exercise price) X Number of shares = Actual gain from sale
($150 - $1) X 1,000 = $149,000
Actual gain on sale - Bargain element = Net gain
$149,000 - $99,000 = $50,000 adjustment for AMT purposes

Example 5: Exercise Options and Sell After 1 Year from Purchase and 2 Years from Grant

06/01/2020 —— 07/01/2021 —— 08/01/2022

Regular Tax:
• Qualifying Disposition. “A qualifying disposition occurs when the employee holds the stock for at least two years from the date of grant and one year from the date of exercise. If the specific holding period requirements are met, then the employee recognizes capital gain (or loss) on disposition of the stock (but there is still no deduction for the employer)… If the option price is not fixed and determinable at the time the option is granted, the option price will be computed as if the option had been exercised on the grant date. See Treas. Reg. § 1.423-2(k)(1)(ii). This compensation income is not subject to FICA, FUTA or FITW. See Notice 2002-47. Any additional gain on the disposition of the stock is characterized as capital gain. See IRC § 423(c). The employer receives no tax deduction for the compensation recognized by the employee under this special rule. See Treas. Reg. § 1.423-2(k)(1)(iii).”
https://www.irs.gov/pub/irs-pdf/p5992.pdf
• Our employer will not report any compensation amount for this sale on our Form W-2.

Schedule D:
• The net gains which is the difference between the sale price and the exercise price times the number of shares and then minus any exercise and sale cost, such as commission or trade fee, is taxed as a long-term capital gain or loss reported on Schedule D.
Sale price - Exercise price X Number of shares = Net long-term gain
($150 - $1) X 1,000 = $149,000

AMT:
• We should have reported the bargain element as income in the year we exercised our ISOs and did not sell the shares on Form 6251, Alternative Minimum Tax.
(Market price - Exercise price) X Number of shares = Bargain element
($100 - $1) X 1,000 = $99,000
Bargain element of $99,000 for tax year 2021.
• In the year-of-sale, Form 6251, an AMT adjustment is added to the stock’s cost basis for Alternative Minimum Tax purposes, but not for the regular tax purposes.

(Sale price - Exercise price) X Number of shares = Actual gain from sale
($150 - $1) X 1,000 = $149,000
Actual gain on sale - Bargain element = Net gain
$149,000 - $99,000 = $50,000 adjustment for AMT purposes

What have we learned?
• To double-check our calculation for the regular tax liability, we can ask ourselves three questions: What are our gross proceeds, what is our cost basis, and what is our net gain?
For example, if our gross proceeds are $150,000, our cost basis is $50,000, and our net gain is $100,000, the different amounts taxed should add up to our net gain. Below are various scenarios illustrating this:
1. $100,000 taxed at ordinary income + $0 taxed at short-term capital gains + $0 taxed at long-term capital gains = $100,000
2. $60,000 taxed at ordinary income + $40,000 taxed at short-term capital gains + $0 taxed at long-term capital gains = $100,000
3. $60,000 taxed at ordinary income + $0 taxed at short-term capital gains + $40,000 taxed at long-term capital gains = $100,000
4. $0 taxed at ordinary income + $0 taxed at short-term capital gains + $100,000 taxed at long-term capital gains = $100,000
• For AMT reporting, in the year we exercised the ISOs and did not sell the shares, the bargain element is an AMT positive adjustment. In the year we sold the shares, an adjustment is added to the stock’s cost basis for Alternative Minimum Tax purposes, but not for the regular tax purposes.

Key Takeaways:
• For regular tax liability, always confirm: gross proceeds, cost basis, and net gain/loss.
• For AMT, account for the bargain element in the year of exercise and adjust the cost basis in the year of sale.

By understanding these scenarios, we can navigate the complex taxation rules for ISOs and optimize our financial decisions. Please note that this material is for educational use only and it’s subject to change. Tax laws are complex, there are exceptions to the rules, and it’s constantly changing. Be sure to talk to a qualified professional before making an informed decision. Thank you for watching. Until next time. This is Tan, your Trusted Advisor.

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Incentive Stock Options Taxation Explained: 5 Real-World Scenarios to Understand ISO and AMT Rules

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