If you sell stock that you acquired by exercising incentive stock options (ISOs), then the tax consequences depend upon your holding period, which is defined as:
How long you held the stock after you exercised the option
How long after the option was granted that you sold the stock
If either of the following situations apply to your sale:
You held the stock that you purchased when you exercised the option for 1 year or less,
-or-
You held the stock for less than 2 years after the option was granted to you,
then part of the profit from the sale is reported as ordinary income (W-2 income) and only any remaining gain is reported as a capital gain. Your employer should include the amount reported as ordinary income in your total earnings on your W-2. If you sold the stock for a loss, then the entire loss is reported as a capital loss.
If both of these situations apply to your sale:
You held the stock that you purchased when you exercised the option for more than 1 year,
-and-
You held the stock for 2 or more years after the option was granted to you,
then the profit from the sale is reported as a capital gain. If you sold the stock for a loss, then you report it as a capital loss.
Your employer granted you an ISO on March 11, 2008, to buy 100 shares of stock at $10 a share. At the time you were granted this ISO, your company's stock was trading on the market at $10 a share. On the date that you exercised the option, January 14, 2010, the stock was trading at $12 a share. On January 24, 2010, you sold the stock for $15 a share.
Because you held the stock for less than 2 years after the option was granted to you (from March 11, 2008, to January 24, 2010), part of your profit will be treated as W-2 income and part will be treated as a capital gain.
The part that is treated as W-2 income is the profit you made from the date of grant to the date of exercise:
$12 (Market value on the date of exercise) - $10 (Amount you paid for the stock) X 100 shares = $200
So, $200 of the profit is taxable as ordinary wage income on your W-2.
The part that is treated as a capital gain is the profit you made from the date of exercise to the date of sale:
$15 (Market value on the date of sale) - $12 (Market value on the date of exercise) X 100 shares = $300
This means that $300 is treated as a capital gain.
It’s very important to keep these rules in mind when you report the sale of stock that you purchased through an ISO. You don’t want to be taxed twice on the same income.
The broker your employer uses to handle the stocks will send you a Form 1099-B, which will include the following information:
The name of the stock and number of shares sold
The price you sold the stock for
Your net proceeds (in most cases)
Read the 1099-B carefully to determine whether or not expenses related to the sale were excluded from the reported proceeds. If expenses weren’t included, make sure to include them in the cost (or basis) of the stock you sold. For more information, see Sale Expenses.
You might receive a statement from your employer that shows the amount included in your W-2 income (if any). If you’re not sure whether any of your gain was included in your W-2 income, check with your employer.
You report your sale in the Sale of Stocks, Bonds, Mutual Funds, and Investment Property section of the Interview. For the Date acquired, enter the date you exercised the options. For Cost or other basis, enter the amount you paid for the stock options plus any of the gain that your employer included on your W-2.
In the example above, here is how you would report the sale:
For the date acquired, enter March 11, 2008
For the cost (basis), enter $1,200:
$10 (Amount you paid for the stock) X 100 shares + $200 (Amount included in W-2 income) = $1,200
For more information, see IRS Publication 525: Taxable and Nontaxable Income.
Incentive stock options have Alternative Minimum Tax (AMT) implications. When you don’t sell the stock you acquired from exercising your ISOs in the same year that you exercised the options, the difference between the amount you paid for the stock and the fair market value of the stock on the day you exercised your options must be added to your AMT income. AMT income is the difference between the price you paid for the stock and its fair market value on the day you exercised the option times the number of shares purchased.
The market value on the day you exercised the option is your AMT basis in the stock you purchased. When you finally decide to sell your stock, you must use the AMT basis for calculating the AMT capital gain or loss. Report the AMT capital gain / loss adjustment in Part I of Form 6251.
Continuing the previous example, because you didn’t sell anything when you exercised the option on January 14, 2010, you didn’t need to report any income on your tax return. However, when you exercised the option, there was AMT income that you needed to report.
The AMT income you generated when you exercised the option on January 14, 2010, was $200:
$12 (Market value on the date you exercised the option) - $10 (Amount you paid for the stock) X 100 shares = $200
Your basis in the stock, for regular tax purposes, is the price you paid for it - $10 per share. Your AMT basis is $12 per share, which was the market value on the day you exercised the option. When you finally decide to sell the stock, you’ll use this AMT basis to calculate the AMT gain or loss.
Important: Make sure you keep a record of the AMT basis in your files so that you can correctly calculate the AMT gain or loss when you sell the stock.