Exercising ISOs.
Tax rules that apply when you exercise an incentive stock option.
One of the key differences between incentive stock options (ISOs) and nonqualified stock options is that you don't have to report compensation income when you exercise an ISO. But you may have to pay a significant amount of tax anyway, because of the alternative minimum tax (AMT).
The description on this page assumes you're using cash (not stock) to exercise your ISO, and that you'll hold the stock for some time, rather than sell it immediately. Later pages deal with the tax consequences of cashless exercise, exercise using stock you already own, and disposition of stock you acquired using an ISO.
Regular tax treatment.
For purposes of the regular income tax, the exercise of an incentive stock option is a non-event. There is no tax — in fact, nothing to report on your tax return — when you exercise an ISO. This is dramatically different from the treatment of nonqualified options. Generally you report compensation income equal to the difference between the fair market value of the stock and the amount paid under the option when you exercise a nonqualified option.
Because you don't report any income when you exercise an ISO, your basis for the stock you acquired is simply the amount you paid for it. Your holding period begins on the day you acquire the stock: you can't include the period for which you held the option.
Alternative minimum tax.
So much for the good news. The bad news is that the exercise of an incentive stock option gives rise to an "adjustment" under the alternative minimum tax. The adjustment is precisely the amount you would have reported as compensation income if you exercised a nonqualified option instead of an ISO. In other words, it's equal to the amount by which the fair market value of the stock exceeds the amount you paid for it (otherwise known as the spread or the bargain element ). For details see Exercise of Nonqualified Stock Options.
The AMT adjustment has three consequences. First and most obviously, you may have to pay AMT in the year you exercise an incentive stock option. There's no way to determine the amount of AMT you'll pay simply by looking at the amount of the bargain element when you exercised your option. The bargain element on your exercise of an ISO may be the event that triggers AMT liability, but the amount of liability depends on many other aspects of your individual income tax return. You may find that you can exercise some ISOs without paying any AMT at all. If your bargain element is large, you should expect to pay AMT as large as 28% or more of the bargain element. (The maximum rate for the AMT is 28%, but the tax resulting from a single large item can be greater than that percentage because of the interaction of various features of the alternative minimum tax.)
The second consequence from the AMT adjustment is that some or all of your AMT liability will be eligible for use as a credit in future years. This credit can only be used in years when you don't pay AMT. It's called the AMT credit, but it reduces your regular tax, not your AMT. In the best case, the AMT credit will eventually permit you to recover all of the AMT you paid in the year you exercised your incentive stock option. When that happens, the only effect of the AMT was to make you pay tax sooner, not to make you pay more tax than you would have paid. But for various reasons you can't count on being able to recover all of the AMT in later years.
The third consequence of the AMT adjustment is very important — and easy to overlook. We noted earlier that the stock you acquire when you exercise an ISO has a basis equal to the amount you paid. But the stock has a different basis for purposes of the alternative minimum tax. The stock's AMT basis is equal to the amount you paid plus the amount of the AMT adjustment. That means you'll report a smaller amount of gain for AMT purposes when you sell the stock.
Example: You exercise an ISO, paying $35 per share when the value is $62 per share. You report an AMT adjustment of $27 per share. Later, after satisfying the ISO holding period, you sell the stock for $80 per share. For purposes of the regular income tax you report gain of $45 per share ($80 minus $35). But for AMT purposes you report gain of only $18 per share. Your AMT basis is equal to the $35 you paid plus the $27 adjustment you reported.
The difference in the amount of gain reported can help you avoid paying AMT on other ISOs you exercise in the same year you sell this stock — or it can help you take advantage of the AMT credit described above. If you overlook the higher AMT basis of this stock you may end up unnecessarily paying double tax with respect to your ISO .

Learn About Incentive Stock Options.
Find out Form 3291 and How Employee Granted ISO Is Taxed.
Incentive stock options are a form of compensation to employees in the form of stock rather than cash. With an incentive stock option (ISO), the employer grants to the employee an option to purchase stock in the employer's corporation, or parent or subsidiary corporations, at a predetermined price, called the exercise price or strike price. Stock can be purchased at the strike price as soon as the option vests (becomes available to be exercised).
Strike prices are set at the time the options are granted, but the options usually vest over a period of time. If the stock increases in value, an ISO provides employees with the ability to purchase stock in the future at the previously locked-in strike price. This discount in the purchase price of the stock is called the spread. ISOs are taxed in two ways: on the spread and on any increase (or decrease) in the stock's value when sold or otherwise disposed. Income from ISOs are taxed for regular income tax and alternative minimum tax, but are not taxed for Social Security and Medicare purposes.
In order to calculate the tax treatment of ISOs, you'll need to know:
Grant date: the date the ISOs were granted to the employee Strike price: the cost to purchase a share of stock Exercise date: the date on which you exercised your option and purchased shares Selling price: the gross amount received from selling the stock.
Selling date: the date on which the stock was sold.
How ISOs are taxed depends on how and when the stock is disposed. Disposition of stock is typically when the employee sells the stock, but it can also include transferring the stock to another person or giving the stock to charity.
Qualifying dispositions of incentive stock options.
A qualifying disposition of ISOs simply means that the stock, which was acquired through an incentive stock option, was disposed more than two years from the grant date and more than one year after the stock was transferred to the employee (usually the exercise date).
There's an additional qualifying criteria: the taxpayer must have been continuously employed by the employer granting the ISO from the grant date up to 3 months prior to the exercise date.
Tax treatment of exercising incentive stock options.
Exercising an ISO is treated as income solely for the purpose of calculating the alternative minimum tax (AMT), but is ignored for the purpose of calculating the regular federal income tax. The spread between the fair market value of the stock and the option's strike price is included as income for AMT purposes. The fair market value is measured on the date when the stock first becomes transferable or when your right to the stock is no longer subject to a substantial risk of forfeiture. This inclusion of the ISO spread in AMT income is triggered only if you continue to hold the stock at the end of the same year in which you exercised the option. If the stock is sold within the same year as exercise, then the spread does not need to be included in your AMT income.
Tax treatment of a qualifying dispositions of incentive stock options.
A qualifying disposition of an ISO is taxed as a capital gain at the long-term capital gains tax rates on the difference between the selling price and the cost of the option.
Tax treatment of disqualifying dispositions of incentive stock options.
A disqualifying or nonqualifying disposition of ISO shares is any disposition other than a qualifying disposition. Disqualifying ISO dispositions are taxed in two ways: there will be compensation income (subject to ordinary income rates) and capital gain or loss (subject to the short-term or long-term capital gains rates).
The amount of compensation income is determined as follows:
if you sell the ISO at a profit, then your compensation income is the spread between the stock's fair market value when you exercised the option and the option's strike price. Any profit above compensation income is capital gain. If you sell the ISO shares at a loss, the entire amount is a capital loss and there's no compensation income to report.
Withholding and Estimated Taxes.
Be aware that employers are not required to withhold taxes on the exercise or sale of incentive stock options. Accordingly, persons who have exercised but not yet sold ISO shares at the end of the year may have incurred alternative minimum tax liabilities. And persons who sell ISO shares may have significant tax liabilities that aren't paid for through payroll withholding. Taxpayers should send in payments of estimated tax to avoid having a balance due on their tax return. You may also want to increase the amount of withholding in lieu of making estimated payments.
Incentive stock options are reported on Form 1040 in various possible ways. How incentive stock options (ISO) are reported depends on the type of disposition. There are three possible tax reporting scenarios:
Reporting the exercise of incentive stock options and the shares are not sold in the same year.
Because you are recognizing income for AMT purposes, you will have a different cost basis in those shares for AMT than for regular income tax purposes. Accordingly, you should keep track of this different AMT cost basis for future reference. For regular tax purposes, the cost basis of the ISO shares is the price you paid (the exercise or strike price). For AMT purposes, your cost basis is the strike price plus the AMT adjustment (the amount reported on Form 6251 line 14).
Reporting a qualifying disposition of ISO shares.
Reporting a disqualifying disposition of ISO shares.
Form 3921 is a tax form used to provide employees with information relating to incentive stock options that were exercised during the year. Employers provide one instance of Form 3921 for each exercise of incentive stock options that occurred during the calendar year. Employees who had two or more exercises may receive multiple Forms 3921 or may receive a consolidated statement showing all exercises.
The formatting of this tax document may vary, but it will contain the following information:
identity of the company that transferred stock under an incentive stock option plan, identity of the employee who exercise the incentive stock option, date the incentive stock option was granted, date the incentive stock option was exercised, exercise price per share, fair market value per share on the exercise date, number of shares acquired,
This information can be utilized to calculate your cost basis in the shares, to calculate the amount of income that needs to be reported for the alternative minimum tax, and to calculate the amount of compensation income on a disqualifying disposition, and to identify the beginning and end of the special holding period to qualify for preferred tax treatment.
Identifying the Qualifying Holding Period.
Incentive stock options have a special holding period to qualify for capital gains tax treatment.
The holding period is two years from the grant date and one year after the stock was transferred to the employee. Form 3921 shows the grant date in box 1 and shows the transfer date or exercise date in box 2. Add two years to the date in box 1 and add one year to the date in box 2.
If you sell your ISO shares after whichever date is later, then you will have a qualifying disposition and any profit or loss will be entirely a capital gain or loss taxed at the long-term capital gains rates.
If you sell your ISO shares anytime before or on this date, then you'll have a disqualifying disposition, and the income from the sale will be taxed partly as compensation income at the ordinary income tax rates and partly as capital gain or loss.
Calculating Income for the Alternative Minimum Tax on Exercise of an ISO.
If you exercise an incentive stock option and don't sell the shares before the end of the calendar year, you'll report additional income for the alternative minimum tax (AMT). The amount included for AMT purposes is the difference between the fair market value of the stock and the cost of the incentive stock option. The fair market value per share is shown in box 4. The per-share cost of the incentive stock option, or exercise price, is shown in box 3. The number of shares purchased is shown in box 5. To find the amount to include as income for AMT purposes, multiply the amount in box 4 by the amount of unsold shares (usually the same as reported in box 5), and from this product subtract exercise price (box 3) multiplied by the number of unsold shares (usually the same amount shown in box 5). Report this amount on Form 6251, line 14.
Calculating Cost Basis for Regular Tax.
The cost basis of shares acquired through an incentive stock option is the exercise price, shown in box 3.
Your cost basis for the entire lot of shares is thus the amount in box 3 multiplied by the number of shares shown in box 5. This figure will be used on Schedule D and Form 8949.
Calculating Cost Basis for AMT.
Shares exercised in one year and sold in a subsequent year have two cost bases: one for regular tax purposes and one for AMT purposes. The AMT cost basis is the regular tax basis plus the AMT income inclusion amount. This figure will be used on a separate Schedule D and Form 8949 for AMT calculations.
Calculating Compensation Income Amount on a Disqualifying Disposition.
If incentive stock option shares are sold during the disqualifying holding period, then some of your gain is taxed as wages subject to ordinary income taxes, and the remaining gain or loss is taxed as capital gains. The amount to be included as compensation income, and usually included on your Form W-2 box 1, is the spread between the stock's fair market value when you exercised the option and the exercise price.
To find this, multiply the fair market value per share (box 4) by the number of shares sold (usually the same amount in box 5), and from this product subtract exercise price (box 3) multiplied by the number of shares sold (usually the same amount shown in box 5). This compensation income amount is typically included on your Form W-2, box 1. If it's not included on your W-2, then include this amount as additional wages on Form 1040 line 7.
Calculating Adjusted Cost Basis on a Disqualifying Disposition.
Start with your cost basis, and add any amount of compensation. Use this adjusted cost basis figure for reporting capital gain or loss on Schedule D and Form 8949.

Introduction to Incentive Stock Options.
One of the major benefits that many employers offer to their workers is the ability to buy company stock with some sort of tax advantage or built-in discount. There are several types of stock purchase plans that contain these features, such as non-qualified stock option plans. These plans are usually offered to all employees at a company, from top executives down to the custodial staff.
However, there is another type of stock option, known as an incentive stock option, which is usually only offered to key employees and top-tier management. These options are also commonly known as statutory or qualified options, and they can receive preferential tax treatment in many cases.
Key Characteristics of ISOs.
Incentive stock options are similar to non-statutory options in terms of form and structure.
Schedule: ISOs are issued on a beginning date, known as the grant date, and then the employee exercises his or her right to buy the options on the exercise date. Once the options are exercised, the employee has the freedom to either sell the stock immediately or wait for a period of time before doing so. Unlike non-statutory options, the offering period for incentive stock options is always 10 years, after which time the options expire.
Vesting: ISOs usually contain a vesting schedule that must be satisfied before the employee can exercise the options. The standard three-year cliff schedule is used in some cases, where the employee becomes fully vested in all of the options issued to him or her at that time. Other employers use the graded vesting schedule that allows employees to become invested in one-fifth of the options granted each year, starting in the second year from grant. The employee is then fully vested in all of the options in the sixth year from grant.
Exercise Method: Incentive stock options also resemble non-statutory options in that they can be exercised in several different ways. The employee can pay cash up front to exercise them, or they can be exercised in a cashless transaction or by using a stock swap.
Bargain Element: ISOs can usually be exercised at a price below the current market price and, thus, provide an immediate profit for the employee.
Clawback Provisions: These are conditions that allow the employer to recall the options, such as if the employee leaves the company for a reason other than death, disability or retirement, or if the company itself becomes financially unable to meet its obligations with the options.
Discrimination: Whereas most other types of employee stock purchase plans must be offered to all employees of a company who meet certain minimal requirements, ISOs are usually only offered to executives and/or key employees of a company. ISOs can be informally likened to non-qualified retirement plans, which are also typically geared toward those at the top of the corporate structure, as opposed to qualified plans, which must be offered to all employees.
Taxation of ISOs.
ISOs are eligible to receive more favorable tax treatment than any other type of employee stock purchase plan. This treatment is what sets these options apart from most other forms of share-based compensation. However, the employee must meet certain obligations in order to receive the tax benefit. There are two types of dispositions for ISOs:
Qualifying Disposition: A sale of ISO stock made at least two years after the grant date and one year after the options were exercised. Both conditions must be met in order for the sale of stock to be classified in this manner. Disqualifying Disposition: A sale of ISO stock that does not meet the prescribed holding period requirements.
Just as with non-statutory options, there are no tax consequences at either grant or vesting. However, the tax rules for their exercise differ markedly from non-statutory options. An employee who exercises a non-statutory option must report the bargain element of the transaction as earned income that is subject to withholding tax. ISO holders will report nothing at this point; no tax reporting of any kind is made until the stock is sold. If the stock sale is a qualifying transaction, then the employee will only report a short-term or long-term capital gain on the sale. If the sale is a disqualifying disposition, then the employee will have to report any bargain element from the exercise as earned income.
Say Steve receives 1,000 non-statutory stock options and 2,000 incentive stock options from his company. The exercise price for both is $25. He exercises all of both types of options about 13 months later, when the stock is trading at $40 a share, and then sells 1,000 shares of stock from his incentive options six months after that, for $45 a share. Eight months later, he sells the rest of the stock at $55 a share.
The first sale of incentive stock is a disqualifying disposition, which means that Steve will have to report the bargain element of $15,000 ($40 actual share price - $25 exercise price = $15 x 1,000 shares) as earned income. He will have to do the same with the bargain element from his non-statutory exercise, so he will have $30,000 of additional W-2 income to report in the year of exercise. But he will only report a long-term capital gain of $30,000 ($55 sale price - $25 exercise price x 1,000 shares) for his qualifying ISO disposition.
It should be noted that employers are not required to withhold any tax from ISO exercises, so those who intend to make a disqualifying disposition should take care to set aside funds to pay for federal, state and local taxes, as well as Social Security, Medicare and FUTA.
Reporting and AMT.
Although qualifying ISO dispositions can be reported as long-term capital gains on the IRS form 1040, the bargain element at exercise is also a preference item for the alternative minimum tax. This tax is assessed to filers who have large amounts of certain types of income, such as ISO bargain elements or municipal bond interest, and is designed to ensure that the taxpayer pays at least a minimal amount of tax on income that would otherwise be tax-free. This can be calculated on IRS Form 6251, but employees who exercise a large number of ISOs should consult a tax or financial advisor beforehand so that they can properly anticipate the tax consequences of their transactions. The proceeds from sale of ISO stock must be reported on IRS form 3921 and then carried over to Schedule D.
The Bottom Line.
Incentive stock options can provide substantial income to its holders, but the tax rules for their exercise and sale can be complex in some cases. This article only covers the highlights of how these options work and the ways they can be used. For more information on incentive stock options, consult your HR representative or financial advisor.

Incentive stock options amt treatment

If you receive an option to buy stock as payment for your services, you may have income when you receive the option, when you exercise the option, or when you dispose of the option or stock received when you exercise the option. There are two types of stock options:
Options granted under an employee stock purchase plan or an incentive stock option (ISO) plan are statutory stock options . Stock options that are granted neither under an employee stock purchase plan nor an ISO plan are nonstatutory stock options .
Refer to Publication 525, Taxable and Nontaxable Income , for assistance in determining whether you've been granted a statutory or a nonstatutory stock option.
Statutory Stock Options.
If your employer grants you a statutory stock option, you generally don't include any amount in your gross income when you receive or exercise the option. However, you may be subject to alternative minimum tax in the year you exercise an ISO. For more information, refer to the Form 6251 (PDF). You have taxable income or deductible loss when you sell the stock you bought by exercising the option. You generally treat this amount as a capital gain or loss. However, if you don't meet special holding period requirements, you'll have to treat income from the sale as ordinary income. Add these amounts, which are treated as wages, to the basis of the stock in determining the gain or loss on the stock's disposition. Refer to Publication 525 for specific details on the type of stock option, as well as rules for when income is reported and how income is reported for income tax purposes.
Incentive Stock Option - After exercising an ISO, you should receive from your employer a Form 3921 (PDF), Exercise of an Incentive Stock Option Under Section 422(b) . This form will report important dates and values needed to determine the correct amount of capital and ordinary income (if applicable) to be reported on your return.
Employee Stock Purchase Plan - After your first transfer or sale of stock acquired by exercising an option granted under an employee stock purchase plan, you should receive from your employer a Form 3922 (PDF), Transfer of Stock Acquired Through an Employee Stock Purchase Plan under Section 423(c) . This form will report important dates and values needed to determine the correct amount of capital and ordinary income to be reported on your return.
Nonstatutory Stock Options.
If your employer grants you a nonstatutory stock option, the amount of income to include and the time to include it depends on whether the fair market value of the option can be readily determined .
Readily Determined Fair Market Value - If an option is actively traded on an established market, you can readily determine the fair market value of the option. Refer to Publication 525 for other circumstances under which you can readily determine the fair market value of an option and the rules to determine when you should report income for an option with a readily determinable fair market value.
Not Readily Determined Fair Market Value - Most nonstatutory options don't have a readily determinable fair market value. For nonstatutory options without a readily determinable fair market value, there's no taxable event when the option is granted but you must include in income the fair market value of the stock received on exercise, less the amount paid, when you exercise the option. You have taxable income or deductible loss when you sell the stock you received by exercising the option. You generally treat this amount as a capital gain or loss. For specific information and reporting requirements, refer to Publication 525.