What are the tax consequences of exercising an ISO?
ISO taxation is complex. The tax impact depends on when you sell or transfer the stock. Four key tax points to know:
- If you hold the shares long enough and thus make a qualifying disposition (e.g. sale or gift), all the gain over the exercise price is capital gain.
- If you do not hold the share long enough and thus make a disqualifying disposition, ordinary compensation income and any capital gains/losses can vary according to the relationship between your exercise price, the market price at exercise, and the sale price.
- The spread on exercise of an ISO may trigger alternative minimum tax (AMT) when you hold the stock through the calendar year of exercise. AMT is a significant factor to consider in your tax planning for ISOs.
- With ISOs, at exercise or later sale you have no withholding at all and no Social Security or Medicare tax.
Beyond the question of whether your exercise triggers the AMT, meeting the holding-period requirements of an ISO can result in substantially lower taxes.
Example: Your exercise price is $10, i.e. the stock price at grant. You exercise when then market price is $15.
|Holding period||Sale price||Taxable income|
|Less than 1 year from exercise||$17||$5 ordinary income (reported on Form W-2) + $2 short-term gain|
|1+ year from exercise, 2+ years from grant||$17||$7 long-term capital gain, no ordinary income|