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ISO & NSO Tax Implications

What are the tax implications of exercising vested ISOs?

Under U.S. tax law, the exercise gain on ISOs is deferred until you dispose of the shares. However, significant exercise gain may result in current year tax liability under Alternative Minimum Tax (AMT). When you exercise the ISOs, you must include the “spread” aka “bargain element” (the difference between the exercise price/strike price and FMV on the date of exercise) to calculate your AMT liability if you hold the shares you acquired through the ISOs at the end of the tax year. The AMT liability can be substantial and the company is not required to withhold any tax when an employee exercises ISOs.

What are the tax implications of selling ISOs?

The tax implications may differ depending on how long you have held the stocks you acquire through the ISOs before you sell. There are two types of dispositions of ISOs. One is qualifying disposition and the other is disqualifying disposition.

In order to meet the requirements for a qualifying disposition, you have to sell the stocks after 1 year from the exercise date and 2 years from the grant date. Any other dispositions that fail to meet the requirement is a disqualifying disposition.

For qualifying dispositions, you will pay tax on the long-term capital gains in the year you sell. For disqualifying dispositions, the bargain element will be included in your total wage and taxed as ordinary income. Meanwhile, you must report the sale on your schedule D. If you sell within one year after you acquire them, it is taxed as short-term capital gain. If you sell after one year from the exercise date, it is taxed as long-term capital gain.

What are the tax implications of exercising vested NSOs?

Unlike ISO, no AMT will be involved for NSO exercise. When you exercise, the “spread” aka “bargain element” (the difference between the exercise price/strike price and the FMV on the date of the exercise) is included on your wage income and reported on the W2. It is taxed at the ordinary income tax rate. Generally, the company will withhold taxes for the ordinary income from NSO exercise.

What are the tax implications of selling NSOs?

When you sell the NSOs, you need to report any gain or loss on the Schedule D. If you sell the stocks after holding for one year, it is eligible for Long-term capital gain treatment. If you sell within one year, it is treated as short-term capital gain.

Should I file 83(b) election when I early exercise stock options?

Section 83(b) election doesn’t apply to vested shares. Therefore, you can only file 83(b) elections when you early exercise the stock options. 83(b) election must be filed within 30 days of your exercise date. Generally speaking, it is suggested to file 83(b) whenever you early exercise your options.

What are the benefits of early exercise?

When 83(b) elections are properly filed, you can recognize income/AMT gain in the year you early exercise rather than wait until the options vest. The advantage of early exercise with 83(b) election is that the bargain element may be smaller now compared to when the options actually vest. Therefore, the AMT that is triggered by the exercise of ISOs may be smaller. Also, the early exercise will start the clock for the long-term capital gain.

The disadvantage of early exercise is that if the company fails and the stocks are worthless, the employee needs to absorb the loss on his/her own.

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