Tax Implications of Incentive Stock Options
You have probably heard that employee stock options (ESOs) are continuously being used by corporations to retain their employees and to lure in new skilled and intelligent employees. You have also probably learned that an ESO is a kind of call option wherein the corporation writes a contract whereby the employee can exercise his right, as holder of the option, to buy shares of the corporation’s stock at an option price for a specific period of time. In addition to this, the employee may face different tax obligations once he is granted with this ESO. What kind of tax implication depends on which type of ESO he was granted with? In general there are three kinds of ESOs: the Incentive Stock Option (ISO), the Employee Purchase Plan (ESPP) and the Non-qualified stock option (NQSO). Each one of these options has differing tax implications. For purposes of this discussion I will concentrate on ISOs.
ISOs, which are also known as statutory stock options or qualified stock options, are ESOs that have tax benefits according to Section 422 of the United States Internal Revenue Code. To qualify as an ISO an ESO must meet the qualifications set by the Internal Revenue Code. Since no profits are received by the employee by merely accepting the grant of the ISO from the corporation then the employee is not taxed yet. It is only upon disposition that certain tax obligations arise for the employee. Disposition means not only selling the stock option or the stocks but also transfer of the option or stock by legal means or by giving it as a gift or exchange. The kinds of taxes that can be levied on the employee will depend on whether he disposed of the stocks within the statutory holding period or if he disposed of it outside of that period. This holding period is either two years from the granting of the ISO by the company or one year from the exercise of the ISO, whichever is later.
If the stocks that were bought by the employee from the corporation were disposed of within the holding period then this is called disqualifying disposition. In which case the employee must face two kinds of taxes: the first one is an income tax to the bargain purchase element which is the difference of the option price and the amount that the stock was being sold at the time of the exercise of the ISO; the second one is a capital gains tax from the difference of the stock price at the time of the exercise of the ISO and the stock price at the time of the disposition. Also, if the disqualifying disposition happens within the same year that the ISO was exercised then an Alternative Tax Adjustment (ATM) will also be added which is computed from the bargain purchase element.
If the employee disposes of the stocks after the holding period then this is called a qualified disposition with only the capital gains tax that will be levied on the employee for the difference of the stock price at the time of ISO exercise and the stock price at the time of disposition.