While ISOs can offer a valuable opportunity to participate in your company's growth and profits, there are tax implications you should be aware of. We'll help you understand ISOs and fill you in on important timetables that affect your tax liability so you can optimize the value of your ISOs. What are Incentive Stock Options?
Part 3: Exercising stock options and taxes
A stock option grants you the right to purchase a certain number of shares of stock at an established price. If you have been granted stock options, make sure you know which type of options you received. If you are not sure, take a look at your option agreement or ask your employer. The type of options should be clearly identified in the agreement.
Why are Incentive Stock Options more favorable tax-wise? When you exercise Incentive Stock Options, you buy the stock at a pre-established price, which could be well below actual market value. The advantage of an ISO is you do not option it to report income when you receive a stock option grant or when you exercise that option.
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You report the taxable income only when you sell the stock. With ISOs, your taxes depend on the dates of the transactions that is, when you exercise the options to buy the stock and when you sell the stock.
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The price break between the grant price you pay and the fair market value on the day you exercise the options to buy the stock is known as the bargain element. There is a catch with Incentive Stock Options, however: you do have to report that bargain element as taxable compensation for Alternative Minimum Tax AMT purposes in the year you exercise the options unless you sell the stock in the same year.
We'll explain more about the AMT later.
How transactions affect your taxes Incentive Stock Option transactions fall into five possible categories, each of which may get taxed minimum option payments little differently. With an ISO, you can: Exercise your option to purchase the shares and hold them.
Sell shares at least one year and a day after you purchased them, but less than two years since your original grant date.
Common times people exercise stock options Ordinary income tax vs. Because you own the stock at this point, any gain you make when you sell is a profit from selling the asset. The ordinary income tax rate is currently almost double the capital gains tax rate, so optimizing your exercise strategy to maximize the benefits of long term capital gains tax treatment will result in lower tax liabilities. In other words, the smaller the gap between your strike price and the stock price when you exercise, the more you could benefit from capital gain tax treatment. Instead, you may only have to pay the lower capital gains tax if you exercise them within—and hold them for—a certain amount of time.
Sell shares at least one year and a day after you purchased them, and at least two years since the original grant date. Each transaction has different tax implications. The first and last are the most favorable.
Beware: Stock Options Will Expire If Not Exercised
The time at which you sell determines how the proceeds are taxed. If you can wait at least a year and a day after you purchase the stocks, and at least two years after you were granted the option to sell the stocks as described in item 5 aboveany profit on the sale is treated as a long-term capital gainso it is taxed at a lower rate than your regular income. Your profit is the difference between the bargain price you pay for the stock, and the market price that you sell it for.
This is the most minimum option payments tax treatment because long-term capital gains recognized in are taxed at a maximum Sales that meet these one- and two-year time limits are called "qualifying dispositions," because they qualify for favorable tax treatment.
No compensation is reported to you on your Form W-2, so you do not have to pay taxes on the transaction as ordinary income at your regular tax rate.
When you sell the stock two years or less from the offering date, known as the "grant date," the transaction is a disqualifying disposition.
What Is A Stock Option?
The amount reported minimum option payments your Form W-2 is the bargain element, which is the difference between what you paid for the stock and its fair market value on the day you bought it. The reported compensation is taxed as ordinary income. Exercise your option to purchase the shares and hold them Grant date.