Incentive stock options (ISOs) allow you to buy company stock in the future at a fixed price equal to or greater than the stock’s fair market value on the grant date. If the stock appreciates in value, you will be able to buy shares at a price below what they are then trading. However, there are complex tax rules that apply to this type of compensation.

 Current ISO Tax Treatment

ISOs must comply with many rules and do receive some tax-favored treatment:

  • You owe no tax when ISOs are granted.
  • You owe no regular income tax when you exercise ISOs, but there could be alternative minimum tax (AMT) consequences.
  • If you sell the stock after holding the shares at least one year from the exercise date and two years from the grant date, you pay tax on the sale at your long-term capital gains rate. You also may owe the 3.8% net investment income tax (NIIT).
  • If you sell the stock before long-term capital gains treatment applies, a “disqualifying disposition” occurs, and any gain is taxed as compensation at ordinary-income rates.

For example, if you were granted ISOs in 2016, there likely is no impact on your 2016 income tax return. But if in 2016 you exercised ISOs or you sold stock you had acquired via exercising ISOs; then it could affect your 2016 tax liability. It is important to properly report the exercise or sale on your return to avoid potential interest and penalties for underpayment of tax.

Future Exercises and Stock Sales
If you receive ISOs in 2017 or already hold ISOs, you have not yet exercised, plan carefully for when you do exercise them. Waiting to exercise ISOs until right before the expiration date (when the stock value may be the highest, assuming the stock is appreciating) may make the most sense. But exercising ISOs earlier can be advantageous in certain situations.

Once you have exercised ISOs, the question is whether to immediately sell shares received or hold on to them long enough to garner long-term capital gains treatment. The latter strategy is often beneficial from a tax perspective, but there is also market risk to consider. It may be smarter to sell the stock in a disqualifying disposition and pay the higher ordinary-income rate if it would avoid AMT on potentially disappearing appreciation.

The timing of the sale of stock acquired via an exercise may also positively or negatively affect your liability for higher ordinary-income tax rates, the top long-term capital gains rate and the NIIT.

Plan Ahead
Remember the NIIT is part of the Affordable Care Act (ACA), and officials in Washington are taking steps to repeal or replace the ACA. The NIIT may not be a factor in the future. Also, tax law changes are expected later this year that might include the elimination of the AMT and could reduce ordinary and long-term capital gains rates for some taxpayers. When these changes might go into effect and exactly what they’ll be is still uncertain.

If you’ve received ISOs, contact your advisor to help you ensure you are reporting everything properly on your 2016 return and evaluate the risks and crunch the numbers to determine the best strategy for you going forward.