ISO Taxation
ISO taxation can be complex, especially given AMT. Here is what you need to know!
Tax Implications of ISOs
ISOs have arguably the most complex taxation amongst the types of stock-based comp. If you have ISOs, there is a lot you can/should know; but at a high level the key things are:
When taxation occurs: ISOs (1) may potentially trigger AMT tax when they are exercised; otherwise (2) taxation occurs when the shares are sold.
Taxation type (it depends): ISOs are more tax-friendly than NSOs in most circumstances, but there are rules and requirements you need to meet in order to qualify for more favorable taxation. Depending on the details when you exercise and when you sell, your ISOs may incur (1) AMT tax, (2) Ordinary Income Tax, and/or (3) Capital Gains (short-term or long-term)
Withholding: Taxes are not withheld on ISOs, regardless of which taxes are triggered and owed
Alternative Minimum Tax (AMT)
When you exercise ISOs, you do not owe regular income tax; but you may owe AMT. The bargain element per share (FMV on exercise date minus the option strike price) is considered income for AMT tax purposes in the year you exercise ISOs (unless you also sold the ISOs in the same year). As such, exercising ISOs could result in you owing AMT tax. For more information see: Alternative Minimum Tax (AMT)
Here's an example: Rocket Ship Co. granted Susan an ISO to buy 1,000 shares, with a strike price of $10 per share. A few years later when the option is fully vested, the stock has a fair market value of $15 per share and Susan exercises all 1,000 shares of the ISO. The stock has a $5 per share bargain element ($15 - $10), resulting in $5,000 (1,000 shares * $5/sh) of AMT income from the bargain element.
Qualifying vs. Disqualifying Disposition (Impacts Taxation)
When you sell your ISO shares, the tax treatment depends on whether the sale resulted in (1) a qualifying disposition or (2) a disqualifying disposition:
Qualifying Disposition
A qualifying disposition for ISO shares has preferential tax treatment, but in order to qualify one must meet two criteria: (1) Must hold/own the ISO shares at least 1 year after exercise before selling, and (2) The ISO grant must have been issued at least 2 years prior to selling. If both criteria are met, then the sale is a qualifying disposition and the gains are taxed as long-term capital gains.
A quick recap of the taxation dynamics for an ISO qualifying disposition are:
No taxation when granted
Exercising will not result in ordinary income tax, but may trigger AMT tax
The sale of shares will be taxed as a long-term capital gains
Note: the sale of shares may help to recoup AMT paid in prior years (see below)
Disqualifying Disposition
A disqualifying disposition for ISO shares does not have preferential tax treatment (except the exemption from FICA taxes). When you sell shares from an ISO, if you fail to meet both of the time criteria noted above for a qualifying disposition, then your sale is a disqualifying disposition, and the taxation is a bit complex (typically treated as ordinary income, but may have a capital gains element as well).
A quick recap of the taxation dynamics for an ISO share disqualifying disposition are:
No taxation when granted
Exercising will not result in ordinary income tax, but may trigger AMT tax
Taxation of the shares at sale may be ordinary income (exempt from FICA taxes) and/or capital gains (short-term or long-term), depending on the circumstances
Note: the sale of shares may help to recoup AMT paid in prior years (see below)
We frequently see ISOs incorrectly entered on tax returns, including returns done by CPAs (who likely don't work with ISOs often). If you have ISOs, we recommend you work with an accountant who frequently works with stock-based-compensation.
Unique Items and Special Situations
Exemption From FICA Taxes
ISOs are statutorily exempt from FICA taxes (Social Security and Medicare taxes). Regardless of whether your ISOs have a qualifying disqualifying disposition, you should not owe FICA taxes on the income/gain (excepting very rare circumstances where your ISO option is sold outright).
No Income Tax Withholding
Employers are not required to (and thus do not) withhold taxes on either qualifying or disqualifying ISO dispositions. But if you have an ISO disqualifying disposition, in most circumstances you will owe income taxes.
Important: Taxpayers may have a significant tax liability at year-end if they have not had ample taxes withheld and/or made estimated tax payments during the year
ISOs Are Less Preferential Than NSOs if You Early Exercise (i.e. 83(b) Election)
ISOs have a unique dynamic for 83(b) elections. Specifically, the election allows for the early recognition of AMT taxes, but not necessarily regular tax. Recall that ISOs need to meet two criteria to achieve a qualifying disposition: (1) Grant issued at least two years prior to sale, and (2) shares exercised at least one year prior to sale.
What's unique for ISOs with 83(b) exercises is that to achieve requirement (2) above ("shares exercised at least one year prior to sale"), the shares need to be both (i) purchased and (ii) vested, for at least one year.
For example, lets say Kris is granted 10,000 shares of a stock option, with a $1 per share strike price, and a 2-year quarterly vesting schedule. Kris then early exercises all 10,000 shares immediately via an 83(b) election. Two years later, a tender offer occurs at $20 per share:
For an NSO grant, Kris could sell all 10,000 shares in the tender offer with long-term capital gains tax treatment.
For an ISO grant, Kris would only sell half of the shares in the tender offer with long-term capital gains tax treatment. The other half would not have been vested for at least one year, and as such, selling those shares would result in a disqualifying disposition.
Ability to Recoup Previously Paid AMT
If you had to pay AMT in the past, you have a credit with the IRS (and if your state charged you AMT, them as well). This credit is subject to being recouped, though the rules around if/how you can recoup the credit is complex.
For technology workers, exercising ISOs is the most common way one ends up owing AMT. But this at least comes with a silver lining -> in that selling said ISOs that triggered AMT is also one of the primary ways to help recoup your AMT credit (though its nuanced and complex). For more info:
Separate Tax Cost Basis for AMT vs. Standard Taxation
Standard taxation and AMT taxation are parallel but separate tax systems. Given that the bargain element when exercising ISOs is considered income for AMT purposes, but not for standard tax -> the tax cost basis of ISO-exercised shares will be different for AMT and standard tax purposes. This is an important way that paid AMT tax can be recouped, so ensuring one tracks (and strategizes for) their separate cost bases is important. For a bit more detail:
The standard tax basis is the strike price or exercise price paid for the shares.
The AMT tax basis is the FMV when the ISO was exercised
When ISOs are sold, these separate cost bases are used to determine the gain or loss on sale for each tax method (standard and AMT)
When filing your taxes in the year of sale, if the AMT tax basis is different than the standard tax basis, the difference should be reported as an adjustment on Form 6251. This adjustment frequently increases the difference between standard and AMT tax, increasing the amount of AMT able to be recouped when the ISO shares are sold
January Exercise ISO Strategy (Primarily For Public Company Employees)
Exercising ISOs early in the year (January is usually best) will frequently provide an individual with the most flexibility regarding the balance between (i) paying AMT, and (ii) intentionally making a disqualifying disposition. More details can be found here: Exercise ISOs Between January and April
FICA Taxes and Withholding May Apply to ISOs in an Acquisition
If ISOs are bought out or canceled--most typically due to an acquisition--the spread between the strike price and buyout price is likely to be treated as normal/ordinary income tax. Relative to some of the unique tax dynamics ISOs have, the buying would likely result in (1) tax withholding being required, and (2) FICA (Social Security and Medicare taxes) applying to the income.
Taxation in an acquisition can be complex, and can differ deal by deal. We highly advise reading company provided materials regarding the acquisition and consulting with a tax professional
Taxation Examples
Qualifying Disposition
Overview. Mark was granted an ISO on April 15, 2018, to buy 100 shares for $10 per share. He exercised the ISO on April 16, 2022, when the shares were worth $20 per share. On April 17, 2023, Mark sold all shares for $30 per share.
AMT income at exercise. In 2022 Mark generated $1,000 in AMT income ($20 FMV minus $10 strike price, multiplied by 100 shares). Whether or not Mark will owe AMT tax on this income depends on his personal financial situation (most individuals are able to recognize some AMT income without triggering AMT tax; for more details see this article).
Long-term capital gain upon sale. In 2023 Mark generated a $2,000 long-term capital gain (100 shares; $30 sale - $10 strike) and will owe long-term capital gains (unless offset by tax-loss-harvesting). If AMT taxes were owed when the ISO was exercised, this sale may also help Mark recoup some of the AMT credit he has for previously paid AMT.
Related Pages
Last updated
