Incentive stock options 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, you can buy shares at a price below what they’re then
trading for. However, complex tax rules apply to this type of compensation.
Current tax treatment
ISOs must comply with many rules but receive 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.
So if you were
granted ISOs in 2016, there likely isn’t any impact on your 2016
income tax return. But if in 2016 you exercised
ISOs or you sold stock you’d
acquired via exercising ISOs, then it could affect your 2016 tax liability. And
it’s 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 that you
haven’t yet exercised, plan carefully when to exercise them. Waiting to
exercise ISOs until just before the expiration date (when the stock value may
be the highest, assuming the stock is appreciating) may make sense. But
exercising ISOs earlier can be advantageous in some situations.
Once you’ve exercised ISOs, the question is whether to
immediately sell the shares received or to hold on to them long enough to
garner long-term capital gains treatment. The latter strategy often is
beneficial from a tax perspective, but there’s also market risk to consider.
For example, it may be better 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 could
also positively or negatively affect your liability for higher ordinary-income
tax rates, the top long-term capital gains rate and the NIIT.
Planning ahead
Keep in mind that the NIIT is part of the Affordable Care Act
(ACA), and lawmakers in Washington are starting to take steps to repeal or
replace the ACA. So the NIIT may not be a factor in the future. In addition,
tax law changes are expected later this year that might include elimination of
the AMT and could reduce ordinary and long-term capital gains rates for some
taxpayers. When changes might go into effect and exactly what they’ll be is
still uncertain.
If you’ve received ISOs, contact us. We can help you ensure
you’re reporting everything properly on your 2016 return and evaluate the risks
and crunch the numbers to determine the best strategy for you going forward.
