Tax treatment for the incentive stock option was created by the Revenue Act of The introduction of restricted shares and performance shares in the s and s diminished its popularity, but stock options continued to dominate through the s, s, and s. In October , section a of the tax code was added by the American Jobs Creation Act of , which set rules requiring the strike price of the option grant to be at least the fair market value, giving rise to the term a valuation.
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In , law professor Erik Lie published a report into the options backdating involving changing the strike price and date of an option after issue, which led to over SEC and DOJ investigations, resulting in 12 criminal sentences. As of , stock options including ISOs are no longer the most common form of long-term equity incentive rewards for executives, with about half given as performance shares, a quarter as RSUs , and a quarter as stock options.
If the shares are sold before this required holding period a "disqualifying disposition" in the same tax year, then the difference between the price at the time of exercise minus the strike price is taxed as ordinary income, and any additional gain on top of the exercise price is taxed as a short-term capital gain. Short-term capital gains are subject to the same tax brackets as ordinary income but are also subject to the 3.
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If the incentive stock option is sold above the strike price but below the exercise price in the same tax year, the income is recognized solely as ordinary income. If sold before the required 1-year holding period in a different tax year.
Even if a disqualifying disposition is made, if the shares exercised are not sold in the same tax year, the holder must calculate to see if any alternative minimum tax is owed. Although ISOs have more favorable tax treatment than NSOs non-qualified stock options or nonstatutory stock options , they require the holder to take on more risk by holding the stock for a longer period of time if the holder is to receive optimal tax treatment. However, even if the holder disposes of the stock within a year, it is possible that there will still be marginal tax deferral value as compared to NQOs if the holding period, though less than a year, straddles the ending of the taxpayer's taxable reporting period.
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Ordinary income from incentive stock options, unlike wage income or income from NSOs, is also not subject to payroll taxes such as FICA. Note further that an employer generally does not claim a corporate income tax deduction which would be in an amount equal to the amount of income recognized by the employee upon the exercise of its employee's ISO, unless the employee does not meet the holding-period requirements and sells early, making a disqualifying disposition. ISOs must be exercised by an employee within 3 months of termination of employment or be forfeited. Since it may be difficult or impossible to sell shares on the secondary market , this would often either force employees to pay a substantial alternative minimum tax liability, or forfeit their earned shares.
To solve this issue, some private companies allow the option to convert ISOs to NSOs, which allows the exercise period to be extended to up to 10 years. The Tax Cuts and Jobs Act of created the 83 i election for tax year , which allows an employee of a company satisfying certain requirements to defer taxation upon exercise for up to 5 years. Note that the strike price for an employee's ISO grant must be set to the current a fair market value of the common shares, which is generally lower than that of the preferred valuation of shares owned by venture capitalists that is quoted in news.
If the employee performs an early exercise and does not fully vest the shares, the exercise price for the unvested shares is returned. In this example, the employee does not early exercise. On February 1, , the employee elects to exercise, or purchase, these vested shares. These shares are now a disqualifying disposition because they were sold before a 1 year holding period. We use cookies to collect information about how our website is used and to improve the visitor experience. Please review our privacy policy for more information.
In addition, Tax Reform revised the individual alternative minimum tax AMT computation with higher AMT income exemption amounts and a higher income point where the phaseout starts. With both types, when the company stock price rises above the exercise price, the stock option has value. But ISOs also carry the promise of preferential tax treatment.
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While a NQSO is taxed at exercise at ordinary income tax rates and subject to employment tax withholding , no tax or withholding is required when an ISO is exercised. If statutory holding periods are met, ISO holders may be able to defer taxation until the sale of the stock, with any appreciation from grant to sale taxed at favorable long-term capital gains rates.
ISOs must comply with numerous statutory requirements in order to receive favorable tax treatment. These and a host of other complexities make ISOs difficult for companies to administer and confusing for employees and employers.
And while Tax Reform may have reduced the number of individuals encountering AMT problems, projecting future tax results remains onerous…and unpredictable. Significantly, more often than not, the potential tax benefits of ISOs are not realized. For example, this happens when post-termination holding periods are extended beyond required statutory limits.