Incentive Stock Options: How Section 422 Tax Treatment Works

There are two types of equity arrangements that receive preferential tax treatment under the US tax code: Section 423 qualified employee stock purchase plans (ESPPs) and incentive stock options (ISOs), which are qualified under Section 422. I recently covered the tax treatment that applies to ESPPs; in this post, I turn to incentive stock options.

What Are the Tax Benefits of Incentive Stock Options Under Section 422?

Options that are qualified under Section 422 offer several key tax benefits to US employees:

• Tax deferral: Participants don’t recognize any income or pay any tax for regular tax purposes until they sell the shares they acquire under ISOs. Thus, participants may be able to defer paying tax on their ISOs until they have sale proceeds they can use to fund their tax obligation. One caveat, however: The gain at exercise of an ISO is a tax preference item for alternative minimum tax (AMT) purposes. This can effectively cancel out this benefit; more on the AMT below.
• No tax withholding: ISOs aren’t subject to tax withholding. This reduces the administrative burden of the plan for the company and allows participants to use those funds for other purposes until they file their tax return. However, participants may view this benefit as a disadvantage if it results in an unexpectedly high amount of tax due with their return.
• No FICA taxation: ISOs are exempt from FICA taxes. Participants pay less tax on ISOs than they would on nonqualified stock options because they won’t have to pay Social Security or Medicare tax on the shares they acquire under the option.

In addition, if employees hold the shares acquired under ISOs long enough, the disposition qualifies for the following benefit:

• Income tax reduction: The gain on the sale that would normally be treated as ordinary income is recharacterized as a long-term capital gain, which is subject to a maximum individual tax rate of only 20%, compared with a maximum of 37% for ordinary income and short-term capital gains.

What Is Required for an Option to Qualify for ISO Treatment?

For an option to qualify for the benefits described above, the plan must meet conditions set forth in Section 422 of the Internal Revenue Code, such as:

• The option must be granted from a shareholder-approved plan that meets certain conditions.
• The recipient of the option must be an employee of the company.
• The option must have a price at least equal to the fair market value (FMV) of the underlying stock on the grant date and cannot have a term of more than ten years.
• The option must be nontransferable, except on death.
• The value of stock that becomes exercisable under an employee’s ISOs cannot exceed $100,000 per year.

For more information on these requirements, see the NASPP’s “Guide to Incentive Stock Options.”

How Does the Alternative Minimum Tax Apply to ISOs?

The alternative minimum tax is a minimum amount of tax that all US taxpayers are required to pay. Some types of income that are exempt from regular income tax are still subject to tax under the AMT. If a taxpayer has income for AMT purposes that they didn’t pay tax on for regular tax purposes, this can cause their minimum tax liability under the AMT to be higher than their regular tax. When that happens, they must pay the AMT instead.

Although the exercise of an ISO doesn’t result in any income for regular tax purposes, the gain at exercise is income for AMT purposes, regardless of whether the shares are sold at that time. If the ISO shares are not sold within the calendar year of exercise, the additional income reported for AMT purposes could cause employees to be subject to the AMT.

Employees who hold ISOs and who are subject to the AMT should be sure to consult their tax advisers before exercising any ISOs. See the NASPP article “Protecting Employees From the Alternative Minimum Tax Trap” for more information.

What Is the ISO Statutory Holding Period?

As mentioned above, employees who hold the shares they acquire under the plan long enough can reduce the tax they pay on their ISO shares. To qualify for this treatment, employees must hold the stock for both of the following periods:

1. Two years from the date the ISO was granted
2. One year from the exercise date

These periods are specified in Section 422, so we refer to them as the “statutory holding period.” When employees satisfy this holding period, we say their disposition is “qualifying.” Dispositions of shares that occur before either of the above periods has elapsed are “disqualifying.”

For more information on how ISOs are taxed, see the NASPP’s “Guide to Incentive Stock Options.”

How Are ISO Qualifying Dispositions Taxed?

When employees dispose of their ISO shares in a qualifying disposition, they will recognize only a long-term capital gain or loss on the transaction. They will not recognize any ordinary income in connection with the ISO.

Let’s look at some examples. Suppose an employee is granted an ISO with an exercise price of $10 per share (the FMV on the grant date) and exercises the option when the FMV is $16 per share.

Qualifying Disposition at a Price Above $10

If the employee disposes of the shares at higher than $10 per share, the employee will recognize a long-term capital gain equal to the difference between the exercise price and the disposition price. For example, if the employee sells the shares for $25 per share, the employee will report a long-term capital gain of $15 per share.

Qualifying Disposition at a Price Below $10

If the employee disposes of the shares at less than $10 per share, the employee will recognize a long-term capital loss on the disposition. This loss is equal to the difference between the exercise price and the disposition price. For example, if the employee sells the shares for only $9 per share, the employee will report a long-term capital loss of $1 per share.

How Are ISO Disqualifying Dispositions Taxed?

When employees sell their ISO shares in disqualifying dispositions, they recognize ordinary income equal to the lesser of the following two amounts:

• The spread, or gain, that existed at the time they exercised the ISO
• The actual gain on the disposition

Let’s look at the same example we used above, but this time assume the shares are disposed of in a disqualifying transaction.

Disqualifying Disposition at a Price of $16 or More

If the shares are disposed of at a price of $16 per share or higher, the employee recognizes ordinary income of $6 per share ($16 per share FMV on the exercise date minus the $10 per share exercise price). Any additional profit is treated as a capital gain, which will be long term only if more than a year has elapsed since the exercise date. For example, if the employee sells the shares for $25 per share, the employee will recognize a capital gain of $9 per share in addition to the ordinary income of $6 per share.

Disqualifying Disposition at a Price Between $10 and $16

If the shares are disposed of at a price that is less than the $16 per share FMV on the exercise date but higher than the exercise price, the employee’s ordinary income will be limited to the actual gain on the sale.

For example, let’s say the employee sells the shares for $14 per share. The employee will recognize ordinary income of $4 per share ($14 per share sale price minus the $10 per share exercise price) and will not report a capital gain or loss.

Disqualifying Disposition at a Price Below $10

If the employee disposes of the shares at less than the exercise price ($10 per share in our example), the employee will not recognize any ordinary income on the disposition and will instead recognize a capital loss (which will be long term if more than a year has elapsed since the exercise date).

What Counts as an ISO Disposition?

In most cases, dispositions are sales of the stock acquired under ISOs. But dispositions can also include other transactions in which beneficial ownership of the stock is transferred, such as gifts and even donations of the stock to charitable entities.

One pitfall to be aware of is that the “lesser of” calculation I describe above for disqualifying dispositions does not apply to some types of dispositions, including wash sales, sales to related parties, and gifts. If these transactions are disqualifying, the employee will recognize ordinary income equal to the spread at the time of exercise, regardless of the value of the shares at the time of the disposition.

What Are the Company’s Reporting Obligations for ISOs?

When ISOs are exercised, the company must report the exercise to the IRS on Form 3921 and provide a copy of the form to the employee. See the NASPP article “Section 6039 Filings: A Complete Guide” for more information on Form 3921.

Although companies do not withhold taxes on dispositions of ISO shares, they are still required to report the ordinary income employees recognize from disqualifying dispositions on Form W-2. Companies do not have any reporting obligations for qualifying dispositions of ISOs.

Learn the Fundamentals of ISOs and Other Types of Equity Compensation

ISOs and other equity awards are a great way to reward employees, but for those unfamiliar with these programs, they can be intimidating to implement and administer. Build your confidence managing ISOs and other equity awards with the NASPP’s online Stock Plan Fundamentals course.