The timing of a sale or disposition is critical to the determination of what sort of tax liability the employee incurs. A summary of the rules follows.
- If the employee sells his or her shares within the same calendar year that he exercised the option (bought the shares), then the gain or extent to which the option is in the money (the market price exceeds the strike price) is deemed W-2 income.
- If the employee sells his or her shares within one year of the exercise date or two years from the grant date, but not in the calendar year in which he or she exercised the option, then the employee's gain is considered ordinary, not W-2 income.
- If the employee sells the shares after one year from the exercise date and after two years from the grant date, then any gain that he or she realizes is a long term capital gain.
In plain language, a disqualifying disposition is when shares are sold before the completion of a statutory holding period. In so doing, the employee is 'disqualified' from having his or her income taxed more favorably than if he or she had waited to sell or dispose of the shares after the completion of the holding period.
- Gains realized from a disqualifying disposition are taxed as ordinary income;
- Gains are recognized in the year that the disqualifying disposition occurs. The ordinary income is included in the basis to determine the capital gain to be recognized due to the disposition;
- If the fair market value of the stock on the sale date is less than its fair market value on the exercise date, then neither a gain nor a loss is recognized upon sale. However, ordinary income is recognized since the employee exercised the option.
Cashless Exercise of ISOs
Financial AdvisorWe look at strategies to help manage taxes and the exercise of incentive and non-qualified stock options.
Managing WealthThese plans can be lucrative for employees - if they know how to avoid unnecessary taxes.
TradingThere are times when an investor shouldn't exercise an option. Find out when to hold and when to fold.
TradingLearn how analyzing these variables are crucial to knowing when to exercise early.
InvestingThere are certain advantages to investing in your employer's stock but there are some potential drawbacks to be aware of.
TaxesA brief intro to the complex US tax rules governing call and put options with examples of some common scenarios.
Personal FinanceEquity compensation can be a lucrative benefit that shouldn't be overlooked at retirement.
TradingThe ability to exercise only on the expiration date is what sets these options apart.