Incentive stock options (“ISOs”) allow you to buy your employer’s stock in the future at a fixed exercise price. The exercise price must at least equal the stock’s fair market value on the date granted. If the stock appreciates above the exercise price, the ISOs will allow you to buy the stock at a price below the fair market value (“FMV”) on the exercise date. However, complex tax rules apply to this type of compensation.
Tax Treatment of ISOs
ISOs must comply with many rules (not discussed here), but receive tax-favored treatment:
GRANT DATE: On the date your employer grants your ISOs - You owe no tax.
EXERCISE DATE (purchase stock at exercise price) On the date you exercise the ISOs:
Exercises and Stock Sales
So, if you were granted ISOs in 2016, there likely isn’t any impact on your 2016 income tax return. But, if in 2016 you exercised ISOs or you sold stock that you’d acquired via exercising ISOs, then it could affect your 2016 tax liability. It’s important to properly report the exercise or sale on your return to avoid potential interest and penalties for underpayment of tax.
If you receive ISOs in 2017 or already hold ISOs that you haven’t yet exercised, plan carefully when to exercise them. Waiting to exercise ISOs until just before the expiration date (when the stock value may be the highest, assuming the stock is appreciating) may make sense. But, exercising ISOs earlier can be advantageous in some situations.
Once you’ve exercised ISOs, the question is whether to immediately sell the shares received or to hold on to them long enough to garner long-term capital gains treatment. The latter strategy often is beneficial from a tax perspective, but there’s also market risk to consider. For example, it may be better to sell the stock in a disqualifying disposition and pay the higher ordinary-income rate if it would avoid AMT on potentially disappearing appreciation.
The timing of the sale of stock acquired via an exercise could also positively or negatively affect your liability for higher ordinary-income tax rates, the top long-term capital gains rate and the NIIT.
Keep in mind that the NIIT is part of the Affordable Care Act (ACA), and lawmakers in Washington are starting to take steps to repeal or replace the ACA. So, the NIIT may not be a factor in the future. In addition, tax law changes are expected later this year that might include elimination of the AMT and could reduce ordinary and long-term capital gains rates for some taxpayers. When changes might go into effect and exactly what they’ll be is still uncertain.
If you’ve received ISOs, contact us. We can help you ensure you’re reporting everything properly on your 2016 return and evaluate the risks and crunch the numbers to determine the best strategy for you going forward. You can reach me at HZemel@BerdonLLP.com or contact your Berdon advisor.
Hal Zemel, a Tax Partner at Berdon LLP, New York Accountants, has nearly 25 years in public accounting and advises businesses in the manufacturing, distribution, advertising, and real estate sectors.