These type of transactions are common for our clients in San Francisco, and increasing in New York, Chicago, Los Angeles, Boston, Austin, and other cities where we have a large client base. Because of our extensive experience with these types of clients, we have seen many variations and scenarios of how the tax effects ultimately are shown on your return. We will attempt to summarize some of these below. Please feel free to leave comments with questions & we will be happy to address.
In order to know the tax implication of ISOs, you need to know the following:
- Grant date: the date when you are granted the options
- Exercise date: the date when you exercise the option and purchase the stocks
- Sale date: the date when you dispose your stocks
- Exercise price: the price you paid to purchase the stocks
- Selling price: the fair market value of stocks when you dispose them
You can usually get this information from Form 3921.
There are 2 types of desposition of ISOs. One is Qualified Disposition of Incentive Stock Option and the other is Nonqualified Disposition of Incentive Stock. In most cases, Qualified ISO is more tax favorable so how do you determine the type of your ISOs? Here is a flowchart.
Scenario 1: Sell the stock at least one year after the exercise date at least two years after the grant date.
In the year of your exercise, you will need to make an adjustment for the Alternative Minimum Tax (AMT), which is usually called “Bargain Element”. Bargain element is the difference between the exercise price and Fair Market Value of the stocks when you exercise the options. It can trigger an AMT liability. However, no AMT adjustment is needed if you sell and exercise Qualified ISO in the same year.
If the sale and the exercise of the options occur in different years, you must make an AMT adjustment in the year of sale as well. You should make a negative AMT adjustment on your Form 6251. At the same time, the sale should be reported on the Schedule D. You will be taxed if there is any capital gain.
Scenario 2: Sell the stocks within one year after the exercise date
Nonqualified dispositions of ISOs will be taxed in two ways: compensation income (subject to ordinary income rate) and capital gain or loss (subject to short-term or long-term capital gain rate).
If the sale and exercise occur in the same year, the bargain element will be included in the total wage (box 1) on your W2. It is taxed at the ordinary income rate. At the same time, you will also report the sale on your Schedule D. The gain will be taxed at short-term capital gain rate. The cost basis will be the actual price you paid plus the bargain element so that you will not be double taxed.
If the sale and exercise occur in different year, there will be a positive AMT adjustment in the year of exercise and a negative AMT adjustment in the year of sale.
AMT is reported and calculated on Form 6251. If you are subject to AMT in the year of sale, the AMT adjustment can reduce your tax liability. If you are not subject to AMT in the year of sale, you can carry forward the unused AMT credit to the future year. AMT credit will be calculated on the Form 8801. Any unused credit will be carried forward to future years. Note that not only Federal has an AMT credit, CA state also have a credit for AMT paid for prior years.
None of this material is tax, legal, or investment advice and is only conversational material provided for discussion purposes only. We are happy to assist with this at our contact information below or through emailing firstname.lastname@example.org