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Bank, and Barclaycard, among others. However, there is one type of stock option plan that is usually only available to executives and upper management. In return for this privilege, incentive stock options must adhere to several rules that do not apply to other types of plans.
While ISOs are also referred to as qualified stock options, they should not be confused with qualified retirement plans that are governed by ERISA regulations. The actual exercise of the stock can take place in a few different ways, depending upon the wishes of the employer and the financial circumstances of the employee:. The taxation of ISOs is what sets them apart from not only their non-qualified cousins, but also all other types of company stock plans.
Most other types of plans require that employees report the bargain element that they receive at exercise as W-2 income, but not ISO participants. If these requirements are met, then the sale is considered to be a qualifying disposition. If Henry were to sell the stock for a price below the exercise price, then he would, of course, declare a capital loss.
If the employee does not hold the stock for the required holding periods before selling it, then the sale becomes a disqualifying disposition. The tax rules pertaining to this type of transaction are a bit more complicated: Employees who make disqualifying dispositions must typically pay withholding tax on the bargain element of the sale, as well as capital gains tax on any profit realized from the sale of the stock.
Dispositions that are made under either of the following two conditions are considered to be disqualifying:. The smaller of the following two amounts must be counted as W-2 income for disqualifying dispositions:.
As with qualifying dispositions, there are no reportable tax consequences for disqualifying dispositions until the stock is sold, regardless of when it was exercised. Therefore, they need to set aside an appropriate amount of cash to cover this amount when they file their returns — or else be prepared to receive a proportionately smaller refund.
Compare how this works with the previous example, assuming the same grant and exercise dates: This is a disqualifying disposition because the entire holding period was only 17 months long. There is another key factor that further complicates the taxation of ISOs. Taxpayers who receive large amounts of income from certain sources, such as tax-free municipal bond income or state income tax refunds, may end up having to pay something known as alternative minimum tax.
This tax was created by the IRS to catch taxpayers who might otherwise avoid taxation through the use of certain strategies, such as moving all of their money to municipal bonds in order to receive only tax-free income. It also disallows some deductions that can normally be taken as well. Participants whose ISO exercises and sales land them in AMT territory can find themselves with a significantly higher tax bill than they would otherwise.
However, the rules and formulas used for AMT calculations are very complex, and any employee who is granted ISOs should immediately consult a qualified tax professional for advice on this matter. In some cases, it may be possible to accurately estimate the number of ISOs that can be exercised or sold without triggering this tax. However, the tax rules that govern them can be quite complicated in some instances, especially when large numbers of options are exercised.
Mark Cussen, CFP, CMFC has 17 years of experience in the financial industry and has worked as a stock broker, financial planner, income tax preparer, insurance agent and loan officer. He is now a full-time financial author when he is not on rotation doing financial planning for the military.
He has written numerous articles for several financial websites such as Investopedia and Bankaholic, and is one of the featured authors for the Money and Personal Finance section of eHow. In his spare time, Mark enjoys surfing the net, cooking, movies and tv, church activities and playing ultimate frisbee with friends.
He is also an avid KU basketball fan and model train enthusiast, and is now taking classes to learn how to trade stocks and derivatives effectively. The actual exercise of the stock can take place in a few different ways, depending upon the wishes of the employer and the financial circumstances of the employee: The amount received is reduced by the amount of the commission charges for the purchase and sale transactions.
The employee keeps the remainder as profit. Key Terms and Dates Grant Date. This is the period of time during which employees can exercise the options that they are granted. This period always begins on the grant date and ends on the expiration date. The offering period for ISOs is always 10 years. Therefore, a purchase transaction always takes place on this date. A taxable event only occurs on this date for ISOs if the spread between the exercise price and the market price becomes a preference item for the Alternative Minimum Tax.
Otherwise, the employee owes no tax on this date. This price may be either the price the stock closed at on the day of the grant, or determined by a specific formula used by the employer. There can be several sale dates to go with a single exercise.
With cliff vesting, the employee becomes immediately vested in all of the options. Tax Treatment of ISOs The taxation of ISOs is what sets them apart from not only their non-qualified cousins, but also all other types of company stock plans. Disqualifying Dispositions If the employee does not hold the stock for the required holding periods before selling it, then the sale becomes a disqualifying disposition.
Dispositions that are made under either of the following two conditions are considered to be disqualifying: Within two years of the grant date Within one year of exercise. The bargain element of the transactions on the date of exercise the price difference between the exercise price and the market price of the stock on the date of exercise The difference between the price from the sale and the exercise price.
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