What Are Incentive Stock Options (ISOs) – Taxation, Pros & Cons

No thanks, I prefer not making money. Cathy has to wait until Nov. A publication of Fairmark Press Inc. Compare how this works with the previous example, assuming the same grant and exercise dates: Your company receives a tax deduction when you make a disqualifying disposition equal to the amount of ordinary income you recognize for your early sale.

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).

ESO Fund takes the risk out of exercising stock options

The tax rules pertaining to this type of transaction are a bit more complicated: Employees who make disqualifying dispositions must typically pay withholding tax on the bargain element of the sale, as well as capital gains tax on any profit realized from the sale of the stock.

Dispositions that are made under either of the following two conditions are considered to be disqualifying:. The smaller of the following two amounts must be counted as W-2 income for disqualifying dispositions:.

As with qualifying dispositions, there are no reportable tax consequences for disqualifying dispositions until the stock is sold, regardless of when it was exercised. Therefore, they need to set aside an appropriate amount of cash to cover this amount when they file their returns — or else be prepared to receive a proportionately smaller refund.

Compare how this works with the previous example, assuming the same grant and exercise dates: This is a disqualifying disposition because the entire holding period was only 17 months long. There is another key factor that further complicates the taxation of ISOs. Taxpayers who receive large amounts of income from certain sources, such as tax-free municipal bond income or state income tax refunds, may end up having to pay something known as alternative minimum tax.

This tax was created by the IRS to catch taxpayers who might otherwise avoid taxation through the use of certain strategies, such as moving all of their money to municipal bonds in order to receive only tax-free income.

It also disallows some deductions that can normally be taken as well. Participants whose ISO exercises and sales land them in AMT territory can find themselves with a significantly higher tax bill than they would otherwise.

However, the rules and formulas used for AMT calculations are very complex, and any employee who is granted ISOs should immediately consult a qualified tax professional for advice on this matter. In some cases, it may be possible to accurately estimate the number of ISOs that can be exercised or sold without triggering this tax. However, the tax rules that govern them can be quite complicated in some instances, especially when large numbers of options are exercised. Mark Cussen, CFP, CMFC has 17 years of experience in the financial industry and has worked as a stock broker, financial planner, income tax preparer, insurance agent and loan officer.

He is now a full-time financial author when he is not on rotation doing financial planning for the military. He has written numerous articles for several financial websites such as Investopedia and Bankaholic, and is one of the featured authors for the Money and Personal Finance section of eHow.

In his spare time, Mark enjoys surfing the net, cooking, movies and tv, church activities and playing ultimate frisbee with friends. He is also an avid KU basketball fan and model train enthusiast, and is now taking classes to learn how to trade stocks and derivatives effectively.

The actual exercise of the stock can take place in a few different ways, depending upon the wishes of the employer and the financial circumstances of the employee: The amount received is reduced by the amount of the commission charges for the purchase and sale transactions.

The employee keeps the remainder as profit. Key Terms and Dates Grant Date. This is the period of time during which employees can exercise the options that they are granted. However, employees who hold ISOs do not do not have to report the bargain element until they sell their shares. The bargain element gets reported as ordinary income if the shares were immediately sold after they were exercised a disqualifying disposition , or reported as a long-term capital gain if the sale was executed one year after exercising the options and two years after the grant date qualifying disposition.

To learn more about capital gains tax, see: An incentive stock option ISO is a type of employee stock option To make the most of employee stock options it's key to understand their risks, tax consequences and how they fit into your financial plan.

ESPPs offer a very straightforward method of allowing employees to participate in the overall profitability of their employers. Before exercising, here are some things to think about if you receive stock options, such as incentive options or nonqualified options from your employer. Tax rules for sales of employee stock purchase plan shares can be tricky.

Here is what you need to consider. Employee Stock Purchase Plans are a benefit that shouldn't be overlooked. This is what you need to keep in mind when evaluating a stock options offer from a new employer.

BREAKING DOWN 'Qualifying Disposition'

What is a disqualifying disposition with incentive stock options, what can cause it, and why does my company care? Disqualifying disposition is the legal term for selling, transferring, or exchanging ISO shares before satisfying the ISO holding-period requirements: two years from date of grant and one year from date of exercise. Disqualifying dispositions. Everyone understands that a sale of the stock within the special holding period results in a disqualifying disposition. It's important to recognize that many other types of transfers can also result in a disqualifying disposition, for example: A gift to someone other than your spouse. 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 .